In downtrend markets as we’ve seen through much of 2022, it’s important to distinguish between price declines that can present themselves in a similar fashion. Active index and fundamental portfolios have evolved, but not all securities evolve for the same reasons. Some investments move because the fair value has gone down; others move because they become “cheaper”. Since indices are designed to be measures of the current market, any market decline experienced in index portfolios is inherently a decline in fair value. However, it is the responsibility of the fundamental investor to isolate securities whose underlying value is less volatile than the prices of the securities, to buy as the instruments become cheaper and to sell when they reach or exceed the price. just value.
To that end, the value investor’s job is not just to find good companies, but to find misunderstood companies. It is a kind of analysis arbitration. The most attractive securities are those that are not only issued by strong companies, but are also cheap. In an undulating market, a value discount can sometimes offset market movements and dampen volatility. In a rising market, earnings can reveal the additional value that can be found in an undervalued security. And when the market or economy faces headwinds, it’s an opportunity to separate the fundamentally challenged from the fundamentally cheap – to avoid the issuer who has experienced a decline in fair value in favor of the issuer which only experienced a price drop.
When looking at the economic environment today, this distinction is particularly notable. The first half of 2022 was a headwind for all credit portfolios, fundamental or not. And there’s no way to sugarcoat why. The risk of a recession in the short or medium term is not low. Wage gains have yet to catch up with recent inflation, and the impact is being felt across the country. However, the fact that consumers are so unhappy with higher prices tells us less about the alleged opportunism of the small business owner than about the visceral impact of higher prices on people’s fiscal confidence. In fact, there are plenty of indicators to show this (see Figure 1).
However, as we move forward into the current earnings season, we are struck by two important observations. First, we have seen the same dynamic seen in mid-2020, where fundamentally attractive bonds that are not members of an index have seen declines in price commensurate with the indices but have not yet experienced the same level. recovery. After all, issuers whose strength is demonstrated by earnings and not by the supply and demand of market indices derive their momentum from quarterly earnings reports rather than real-time based on market correlations. Additionally, the types of value-oriented investors who buy such bonds between earnings tend to be more opportunistic, taking longer to accept that the fair price to pay is higher than the lowest price paid recently. . This means that the payback period for these bonds is not as immediate as for higher beta securities. As a result, returns on securities with a fundamental investment thesis are currently higher on average than the return on equity indices. This is not always the case and shows relative desirability through careful stock selection in the current environment.
However, this brings us to our second observation. Babies are thrown out with the bathwater, often because of the very misunderstandings that fundamental investors seek to exploit. For example, recently, the low revenues of the company Bed Bath & Beyond (BBBY, Financial) pushed the market to sell bonds issued by Michaels as a sign of sympathy. At first glance, the reasons were logical. Costs were higher and supply chain issues were at the forefront. However, a failure to appreciate the difference between the underlying customers of the two issuers or the dynamics driving those customers to shop is also evident in the resulting analyst reports. The comparison stopped at the platitudes: they are both brick-and-mortar retail businesses with potential cost and supply issues due to inflation.
However, what Michaels has demonstrated during the COVID-19 pandemic and the resulting quarantine(s) is that it is a company that is doing well in these difficult economic times. Despite the impact of recession fears and uncertainty on retail as a whole, artisans and other artists are leaning on their hobbies in such environments. Even more so for shoppers looking for the basic types of supplies found at Bed Bath & Beyond, which can also be easily found on Amazon (AMZN, financial) or at Target, (TGT, Financial), Michaels’ main client has few alternatives. Meanwhile, where the Bed Bath & Beyond guest’s discretionary spending can be reduced, the equivalent at Michaels tends to be seasonal or during holidays. That doesn’t mean consumers won’t cut back on spending, but as we’ve seen over the past two years, celebrating occasions when possible can be a relief valve from the overall feeling of pressure on the wallet.
Often, when we think of opportunistic investors, we imagine hedge funds taking outsized risks and profiting if they are right. However, there is another form of opportunistic portfolio management that is more about exploiting misunderstandings in the fundamental nature of a business. In this example, the underlying dynamics of these two companies are different, but the current market has treated them the same. It seems that most analysts’ conclusions stop at a superficial view of a company and credit metrics. But therein lies the opportunity.
Venk Reddy is the Chief Investment Officer of Sustainable Credit Strategies at Osterweis Capital Management. Founded in 1983, Osterweis Capital Management is an independent asset manager with over $7 billion under management as of March 31, 2022. The firm provides investment management services to institutions and individuals through mutual funds and segregated accounts, offering both equity and fixed income investment strategies. . Learn more about www.osterweis.com.
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