February 2013 – Monthly Commentary
February witnessed a reversal in market sentiment as the bond market stabilized and equities continued their upward trajectory. Performance of the capital markets in February reminds us of the memorable line from the 1978 college frat-party movie, Animal House, in which Dean Wormer advises “Flounder” that “…fat, drunk, and stupid is no way to go through life.” Driven by a seemingly insatiable risk appetite and intoxicated by free money courtesy of the Federal Reserve, investors seemed to have forgotten security analysis in valuing capital market assets. Evidence of such reckless behavior could be found in abundance.
The most glaring example is the levered buyout of Heinz by the Brazilian investment firm 3G. On the morning of Valentine’s day, news hit that 3G and Warren Buffet would be teaming up to buy the 144 year old ketchup seller. The media treated the acquisition as another successful Berkshire Hathaway acquisition. In reality, it was a savvy financing deal for the Oracle of Omaha, and likely to be not such a great deal for the company. With no clarity on the post-deal capital structure, bond holders immediately assumed the worst and pushed bond prices lower. As the news was disseminated, it became clear that Berkshire Hathaway’s participation was through the purchase of preferred stock paying an annual dividend of 9%. With the cost of cash virtually zero, 3G’s borrowing rate of 9% bordered on usury. With this, we expect that Heinz will suffer the fate of First Data Corporation and Sallie Mae, two former investment grade companies that were purchased via leveraged buyout, both of which had their credit rating reduced to junk status and have stayed there since. Moreover, the amount of debt they’re piling onto the company make the probability of an ultimate bankruptcy of Heinz a material probability. Reflecting that possibility, Moody’s and S&P put Heinz debt, which prior to the acquisition was rated BBB-, on negative outlook, while Fitch downgraded the company to junk. Such leveraged buyouts are the bane of investment grade fixed income managers, as blue-chip credit credits are downgraded swiftly to junk. Low rate, easy money is rocket fuel for leveraged buyouts, and we may be on the cusp of a leveraged buyout boom.
News of the deal prompted investors to pour money into the equity market, which at month-end had gained 6.6% year-to-date. Of course, Heinz-like, steady growth blue chips benefited the most, with 3M rallying 12.6% for the first two months of the year, and FedEx and General Mills, both gaining more than 15% for the period. Looking more broadly, the S&P appears to be is in a virtuous circle of higher and higher prices. The catalyst has been corporate buying. Over the last two years, corporations have been buyers of their own stock in the secondary market. Despite net selling by individual investors, it’s estimated that equity issuance (new issuance less corporate buyback) has contracted by approximately $426 Billion over the last two calendar years, which has supported stocks. However, since the first of the year individual investors have turned bullish as evident in the $37 billion net cash flow into U.S. mutual funds. That’s in addition to the continued corporate buying. Further fueling the buying binge is the zero interest rate policy. The recent John Deere note offering is a perfect example. The company’s $1 Billion deal was split about evenly between a two-year floating rate note and a five-year note. The floater pays an initial coupon of 0.33%, while the five-year note pays 1.30%. The company has said that they will use the proceeds of the offering for general corporate purposes, including stock buyback. With an earnings yield of 8.75%, and an average borrowing cost of 0.81%, John Deere will boost its earnings per share with the action. The strategy is a sensible one and the increased EPS is likely to prompt investors to join the company in buying the stock. However, the strategy is not without risk. If earnings disappoint, investors could punish the company for making its balance sheet more risky and failing to meet operating expectations, resulting in heightened stock price volatility. Similarly, the company risks artificially pushing up the price of its stock, only to find an absence of buyers when their buying program ends. In essence, they risk “pumping and dumping” their own stock. The John Deere notes are not held by any client account.
Yet another example of the distortive effects of the Federal Reserve’s easy money policy is the recently issued bonds of Whirlpool, the Michigan-based manufacturer of household appliances. The company issued 10-year and 30-year debt last month. Wall Street dealers estimated that the interest rate spread above the risk-free rate on the 10-year would be approximately 210 basis points. We believe the company suffers from a heightened level of revenue volatility, and is not very good at generating cash. In 2012, Whirlpool generated $59 million in cash flow following two years of losing cash. Moreover, upon closer inspection we discovered that the company has an underfunded pension that has ballooned from $400 million in 2002 to $1.6 Billion on December 31, 2012. Given the size of the underfunding, it would take Whirlpool 26 years to fully fund the pension with the amount of cash generated last year, assuming no change in the underfunding. Ironically, demand for the new issuance was so great that the spread to Treasury note’s narrowed from 210 basis points to 175, a sizable move for a new issue corporate. The Whirlpool debt is not held by any client account. We suspect that investors were quick to buy the recognition of the name without doing much analysis. As with the forecast for Heinz, we believe there is a material probability that Whirlpool is downgraded to junk at some point in the future. “Fat, drunk, and stupid” is no way to manage money.
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Specific companies or securities mentioned in this publication are meant to demonstrate Halyard’s investment style and the types of industries and instruments in which we invest and are not meant to be recommendations and are not selected based on past performance. The analyses and conclusions of Halyard contained in this presentation include certain statements, assumptions, estimates and projections that reflect various assumptions by Halyard concerning anticipated results that are inherently subject to significant economic, competitive, and other uncertainties and contingencies and have been included solely for illustrative purposes.