Francis Chou: Investing in Debt Securities
While the following focuses on our experience with non-investment grade debt securities, it is largely applicable to investment grade securities as well.
When we look at what happened in 2008, we learn that a number of investment grade securities were quickly downgraded to non-investment grade. We also learn that investors cannot rely on rating agencies for guidance, even for investment grade securities. Rather, that investors must do their own due diligence and rely on their own experience and judgement.
Many investors are afraid to touch non-investment grade debt securities fearing that such companies may soon need financing or refinancing. These investors especially fear that troubled companies may not be able to refinance their debt, or if the companies restructure their debts, they risk losing some or all of their investment.
While we agree that investing in non-investment grade securities can be tricky, we have not shied away from them when we believe their prices provide us with an attractive return and adequate margin of safety. Although we have made our share of mistakes, over the long-term, we have been pleased with our results. I would like to share with you what has worked for us and the pitfalls we try to avoid.
Before we invest in troubled companies we always ask questions and base our decisions on some of the criteria outlined below. It is impossible to list all the criteria but these are the main ones we look for:
1) Where does the debt security we are considering rank in the company's capital structure? And what would the company be worth if it had to liquidate?
We start by setting a desired target rate of return, and then try to buy the most senior security in the capital structure that meets the return target. We know that in a restructuring, it's a dog-eat-dog world, and senior holders will show no mercy to investors holding lower ranked securities. Experience proves it is prudent to give up some return by buying senior debt versus taking a chance on more junior securities even though they have the potential to earn a much higher return.
For example, imagine two scenarios with scenario-one offering the prospect of recovering 50 cents on the dollar for a junior security trading at 25 cents on the dollar, and scenario-two offering the possibility of recovering 100 cents on the dollar for a senior security that is trading at 80 cents and that is backed up by 200 cents of collateral. The wise course, in our view, is to invest in the second scenario and not succumb to the temptation of the first as we believe maximizing the margin of safety on the principal invested is just as important for debt securities as it is for equity securities.
2) How competent is management? Assessing the competence of management is as critical when buying debt securities as it is when buying equities. In the financial crisis of 2008, when money was tight, a lot of companies were facing liquidity issues. When companies need financing or refinancing, they are in a bind and require strong, competent managers who can run the operation while navigating the restructuring process. As a result, we seek management teams that are passionate about their work and own enough equity in their company to care deeply about its future. We are not interested in companies with managers who are just doing their job, collecting their salaries, stock options and other perks. And we are especially averse to CEOs who view their companies as a job for fear they'll do a job on investors, that is, deliver 'just over breakeven' (job) profits. We are always on the look-out for competent CEOs and management teams who think and act like owners. One of the best times to invest in a debt issue is when a company is facing a short-term liquidity issue rather than an operational issue.
3) Is the underlying business strong and able to generate consistent free cash flow? The economics of a business are important. Ultimately, a company has to repay or restructure its debt. In either scenario, having a strong underlying business that can generate strong cash flow can be vital. Strong cash flows make it easier for companies to repay or refinance debt, or sell assets at higher valuations. One must be careful when buying into an industry with excess capacity since overcapacity is normally equated with negative or below average return on capital.
4) What do the bank and bond covenants look like? Is there a cash flow sweep recapture? In some instances, debt comes with a cash flow sweep, which means that free cash flow left after all the needs of operations have been met can be used to buy back debt at par from debt holders. This cash flow sweep could be monthly, quarterly or yearly. For example, R.H. Donnelly's bank debt has a quarterly cash flow sweep and is trading at 77 cents. However, every quarter, whatever free cash flow that is left is used to buy back the bank debt at 100 cents.
5) What does the company's balance sheet look like and what is its liquidity position? Will it need to raise additional capital? It is important to understand the liquidity position of the company and know if it has adequate resources to pay interest on current debts and any debts that may be maturing. If the company has to raise capital to meet its financing and operational needs, oftentimes this capital is very expensive and dilutive to existing bondholders.
6) If the company goes through a restructuring, will it cause permanent damage to the business by diminishing the value of the brand or by alienating customers? If the company decides to restructure, it has implications not only for the company and its employees but also for its customers. It is critical to understand the impact on customers and if they will continue to do business with the company or move to a competitor instead. If it is the latter, there will be diminished revenues and possibly negative cash flows.
One of our best deals involved Brick Ltd., a retailer of largely lower-end household furniture, mattresses, appliances and home electronics, which we purchased for the Chou RRSP Fund. We attended a meeting during which an executive succinctly described the reasons for their operational problem thusly: 'We tried to go to the middle of the road, and the oncoming traffic killed us'. Brick Ltd. had a financing/liquidity issue in 2009 and in May of that year, succeeded in raising $120 million to recapitalize their balance sheet, pay off senior notes and partially repay their Operating Credit Facility. We were already impressed with the company and were further impressed when the founder of the company said he was willing to invest $10 million on the same terms as the other debenture holders. The Debt Unit consisted of $1,000 principal amount 12% senior secured debentures maturing in five years, and 1,000 Class A Trust Unit purchase warrants. Each warrant entitled the holder to purchase one Class A Trust Unit for a strike price of $1.00, which was very close to the stock's trading price.
Under the able stewardship of Mr. Bill Gregson, Brick continues to make a remarkable turnaround. A $1,000 investment is now worth $2,925, not counting the 12% coupon that we have been clipping all along.