Sheldon Stone of Oaktree Capital describes the eight risks his team assesses before buying a company’s bond.
“The most important thing we do is measure risk,” says Sheldon Stone of Oaktree Capital, co-manager of the St. James’s Place International Corporate Bond fund. “The reward is well known – it’s the yield on the bond and it’s unlikely to differ very much. The risk that you may not get back that promised return is what you really have to focus your efforts on.”
Stone is very clear on the overarching aim of Oaktree’s portion of the fund, which employs a strategy of predominantly investing in a portfolio of senior secured high-yield bonds issued by (in Oaktree’s case) North American companies. (Senior secured bonds are the most financially secure form of high yield debt.)
This approach is designed to provide superior long-term performance by minimising losses, providing good absolute returns in buoyant periods, and outstanding results when markets are struggling. Yet the team at Oaktree operates on the basis that its bread-and-butter work is to worry about what might go wrong.
The Oaktree approach uses an ‘eight-factor model’ to produce a thorough assessment of a company’s risk profile. Each factor is ascribed a score of either one, zero or minus one – equating to positive, neutral or negative – although three of the factors are double-scored to reflect their greater significance.
“We call it our ‘credit scoring matrix’,” says Stone. “The first two factors are similar to equity research [factors]. Initially, you want to understand the industry, the trends, barriers to entry, cyclicality, and any relevant secular trends. For example, traditional media has suffered recently and is not quite the business it used to be – newspapers, radio and so on.”
One of Stone’s holdings is the recording giant Warner Music Group. The company operates in an industry that is rapidly shifting away from album and CD sales to music streaming. Some companies are already getting badly hurt by the disruption, but Warner Music relies on song rights – Stone points to its “illustrious catalogue” that offers a kind of downside protection.
“The second big question is: ‘Would anyone care if the company vanished?’ Does it have critical mass, good market share, proprietary products, and something that makes it distinctive? If the score is negative for both the first two factors – industry and company – nothing else can make up for that.”
When a company has passed the initial two tests, Oaktree then turns its collective attention to the people. Its concern is to see whether the company hires good people with relevant experience, whether those people have a stake in the company, and whether they have the capacity to cope with tougher periods for the business, or for the wider industry. The stewardship of the company is important for this test; if the management team is really poor, Stone is unlikely to invest in the company’s debt.
If Oaktree is satisfied that these three areas – each of them a potential deal-breaker – are company strong suits, then attention turns instead to financial affairs. The ability to service debt, the fourth assessment factor, receives a double-score because it gauges the probability of the company defaulting. Assessing this question requires close analysis of a business’s fixed and variable costs, and means conducting stress tests to ascertain whether the margin for error is sufficiently wide to withstand a bad period.
If the default risk is low, then the capital structure – the fifth factor – comes under scrutiny. On this issue, Oaktree ultimately wants to know how quickly the bondholder would lose money if things went wrong – or, put another way, how many other investors would have to take the hit first.
“This is the right hand of the balance sheet,” says Stone. “How much senior debt is there? How much equity cushion? The big question here is really: where do I fit in the pecking order?”
The sixth and seventh factors on the list both receive double scores. The sixth is cash supply, or liquidity. Stone found that companies with ready access to cash (or which have the latitude to, say, encash some of their business units) tend to survive much better than those without such access. It was a lesson he learned during the global financial crisis.
“I can think of companies that would not have survived if they didn’t have financial flexibility,” says Stone. “One is HostGator, which is the backbone of a lot of e-commerce. Another is Home Depot Supply (better known as HD Supply). Both of these would have failed were it not for the fact that the companies had covenant-light bank loans and, hence, a lot of flexibility over payments. In fact, a number of companies avoided what looked like a probable default during the crisis because they were able to draw down their bank lines.”
The seventh factor is recovery – how much you are going to lose if there is a bankruptcy. Again, this is double-scored, running from two to minus two. The final factor is covenants. The legal agreement can’t prevent you making losses on a bad loan, but it can protect you against ‘event risk’, such as the company making a sudden decision to go private or to take on large amounts of debt.
Oaktree’s investment record suggests that, painful as it may be, imagining everything that might go wrong pays off in the long run.
The opinions expressed are those of Sheldon Stone of Oaktree Capital as of June 2017 and are subject to change at any time due to changes in market or economic conditions. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any strategy. The views are not necessarily shared by other investment managers or St. James's Place Wealth Management.