Invest Like the Best with Patrick O'Shaughnessy - Bryan Krug – High Yield Credit Investing - [Invest Like the Best, EP.114]

Episode Date: December 11, 2018

My guest today is Bryan Krug, who manages the Artisan Partners Credit Team and overseas more than $3B in high yield credit investments for the firm. This was my first conversation on high yield, so I took it as an opportunity to get an overview on the investment universe and home in on the tools used for analysis and security selection. As an equity investor, I think one of the most fruitful areas of research is into ways that companies fail or go wrong, and credit investors focus almost entirely on this potential for impairment. My guess is that all equity investors will learn something useful from this conversation. Please enjoy. For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub. Follow Patrick on Twitter at @patrick_oshag   Show Notes 2:11 – Overview of the high yield debt markets 5:05 – Why should investors consider this investment class 7:11 – How analyzing a company’s debt is different from what equity analysts look for 8:42 – Primary factors when exploring a company’s ability to de-lever 9:43 – What is their alpha vs others in the space 12:02 – Deep dive into the quantitative factors for them to look into a deal 14:25 – Benchmarks he uses 16:08 – Portfolio construction 17:15 – Their preference for broadband providers over cable tv networks 20:01 – What piques his interest about spreads 21:50 – The ratings of debt 25:40 – A recent example of an opportunity and how the mispricing was identified 29:17 – Most valuable data sets in this world 31:51 – Favorite part of this process 32:26 – Most surprising new learning 33:01 Maintaining your advantage 34:49 – The biggest pools of error in this industry 48:00 – What industries interest Bryan 40:50 – Dedication to this market 41:45 – Evolution of his healthy skepticism 42:38 – Can things in the debt market help to project what will happen in the equity markets 44:56 – Current view of the world based on what is happening in the credit markets 45:51 – Categories of convenience that he cares about 49:15 – Anything that has him worried in high yield markets 50:38 – Kindest thing anyone has done for Bryan   Learn More For more episodes go to InvestorFieldGuide.com/podcast.  Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub Follow Patrick on twitter at @patrick_oshag

Hello and welcome, everyone. I'm Patrick O'Shaughnessy, and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfieldguide.com. Patrick O'Shaughnessy is the CEO of O'Shaughnessy Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaunacy Asherty Ascent Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Oshonosha Asset Management may maintain positions and the securities discussed in this podcast. My guest today is Brian Krug, who manages the Artisan Partners Credit Team and oversees more than $3 billion in $3 billion in high yield investments for the firm. This was my first conversation on high yield, so I took it as an opportunity to get an overview on the investment universe and hone in on the tools used for analysis and security selection.

As an equity investor, I think one of the most fruitful areas of research is into ways that companies fail or go wrong. And credit investors focus almost entirely on this potential for impairment. My guess is that all equity investors will learn something useful from this conversation. So please enjoy. Maybe before we get into what opportunities or dangers the credit cycle creates at different points, you could outline, because this is the first time I've had any conversation with anyone specifically about the high yield universe. and really about fixed income in any level of detail, to be honest, much more of an equity guy. So maybe highlight what that universe of high yield looks like, how it's defined.

And from that definition, we'll kind of get into some of the more particulars. So let's talk a little bit about the evolution of the markets. And I think that we kind of give some very good context as to how things have been in the past and how they're going in the future. So if you look historically, if you go back 20 to 30 years, the high yield market was a subordinate credit solution for companies that the banks wouldn't lend to. So in the past, banks used to lend, and they would lend to typically, let's just depend on the business between three to four times debt to EBITDA. And then when companies wanted incremental leverage, the banks wouldn't take that risk. So a public market solution occurred, which was basically the high yield market. And the high

yield market really started in the early 80s, and it's grown pretty significantly through predominantly the growth of alternatives. So if you think of alternatives, private equity, as an example, private equity uses high yield to basically leverage their equity turns. And it's also grown through companies that have incurred capital to build out CAPEX. So examples would be MGM or Wynn. Those casinos were built with high yield capital. Sprint used high yields capital to build its network out. So those are examples of businesses that actually have like tangible needs for it.

So that's how it started out. The banks used to lend and then high yield was the more junior capital solution for the fixed income side. Then structured credit happened probably about 15 years ago. It became much more universally accepted. And the loan market moved from a bank-owned market

to a syndicated public market. And what happened is structured credit made it cheaper for syndicated structures such as CLOs to essentially give risk to companies cheaper than banks could do it. And you also have regulatory changes where it was more expensive for banks to hold that capital from a risk way of capital perspective. So banks moved from an origination model where they used to originate and retain the risk to a syndication model. And the syndication model essentially evolved to where investors such as ourselves, CLOs, and other manager essentially take that risk and a more senior part of the market. And so that started 15 years

ago and that market essentially went from nothing to a trillion dollar market in the last 15 years, give or take. So that's been a significant growth on the loan side. The way that the public high yield and the public loan market's work is typically the loan market is your more senior tranche. It's often floating rate. Its characteristics are that it has limited call protection, which is important because if there's a lot of demand for loans, the spreads will compress. And it's similar to like a mortgage where if you have a rate of 5%, if market rates are 4% for your mortgage, essentially refinance.

And so it's capital that issuers have the ability to reprice. High yield market is typically 7 to 8 year maturity on average. It is typically non-call for approximately the first three to four years. And there's a call premium of four to five points at that time. And so if the company wants to address the maturity earlier, there's breakage that the issuer must pay to move on. So that's actually a big benefit to owning a high yield piece of paper. Maybe you could talk a little bit about the idea for investors of why to allocate to this specific asset class relative to investment grade bonds and maybe also compared to equity. So if you think about those two plus maybe cash as big primary asset classes, what are the behavior points that distinguish this asset class?

and what are the primary motivations you find for, let's say, your customers for investing in this group to begin with? So if you look at the return characteristics in risks of high yield and leverage loan investment, it's a little bit of a hybrid between the two. And different points of the cycle, they have different characteristics. So there is clearly more economic sensitivity to a credit investment relative, a high yield or loan investment relative to a investment rate investment. that's very obvious.

In exchange for that, investors get incremental spread. So that is one factor. Relative to equities, credit does not experience nearly the same amount of volatility as equities do. If you look at the high-yield market and aggregate, leverage as you define debt to EBITDA is around four and a quarter times in the market. If you look at the S&P mid-cap example, as an example, the EV to EBDA is around 12 times, which is very comparable. So you're not taking the same amount of valuation risk broadly across the market, obviously realizing within various companies are going to be different leverage points.

But if you just look broadly out there, the risk is not nearly that of equities into the volatility. It's generally less with the exception of when you have the 08 example. It's kind of a little different example. We can get into that later if you'd like where there was a lot of leverage that was unwound at that time period. So generally, if you look at returns, the high yield has had three negative return years in the last 35 years, which is actually very benign. And if you look at returns going forward and invest, we're underwrite between 6 and 8% IRAs today, depending on the risk across the portfolio. You mentioned before we started recording that when you began in the industry, you thought maybe you'd be in the equity world, but that the nature of evaluation or analysis and your skill set, just like, itself better to this world, kind of a more fundamental view on what's the ability of this company

to repay its loans. So maybe talk about from that perspective the primary differences that you think of as like the work itself of an equity analyst looking at a given company. There was an example that you sent J. Kruh at one point versus a debt analyst. What are the primary gaps between the things that they care about and how they think about those things? A lot of the investments that are made in the high yield and loan market are actually to privately held companies. So we don't have, there is some similarities. There are some differences. The J-Crew example is actually private equity-owned asset that we gave it as an example. Some of the differences are we are much more fundamental. We are looking for basic core, as we get the business, what is the defenseability

of the business? What's the cash flow stream? What's the ability of the company to de-lever its balance sheet? That is the primary metric that we look at is the company's ability to basically de-lever the business. And that's a little different than equity where I think there's a little more expectations in terms of growth rates. How will the company do relative to street expectations? Will there be earnings revision positive or negative? We're a little more fundamental. Like, is this a good business?

Is this business going to de-lever? And then what are the priorities for that cash flow? And what is the credit? How do we think the credit will evolve? Talk more specifically about that ability to de-leverage. So my view is like if you keep asking why, usually you get down to like specific data sets or specific spread. sheets, the units of work themselves that determine these ideas. So when you talk about the ability to de-leverage, what are like the primary factors that you would think about to determine that?

We tend to look at business quality first. So we tend to look for businesses with high recurring revenues, low capital intensity, generally higher margin profiles. And those companies generally have strong free cash flow to debt and examples of areas that we have significant overweights that zip those financial characteristics are insurance brokers, their software businesses, where they have low 90s retention rate before the Salesforce does anything, after the sales force is able to grow organically low single to double digits, a predictable cost structure. And those characteristics generally support strong enterprise values, which also gives us downside protection. How do you think about your own individual advantages versus other high yield credit investors?

So I always like to ask, like, what is it that you do that others either can't or won't do? And how is that something that's sustainable? So how does an advantage persist through time? There's a couple things that we feel like that we do differently from some of our peers. One is we are cash-filled lenders at par. We tend to look at asset value in a more stressed scenario. A lot of our peers will tell you that they look at assets to protect them. Acid value can evaporate pretty quickly.

This fundamentals change. And so the best example of that would have been the energy market. So the energy market is very asset heavy. You have oil and its acreage is worth X per acre. However, that math changes dramatically as the price of oil goes from 100 to 30. And the average E&P as an example, which was perceived to be high quality, dropped roughly 55, 60 points from par to roughly 35 to 40 cents on the dollar in Q1 of 16. into that asset value at par basically didn't help you. And I think a lot of our peers will say,

oh, you know, that's how they think first. We tend to get cash flow and ability to de-labor the business. So that's one big differentiator. From our research perspective, I think we believe in the main and the machine. And so as part of our process, we spend a lot of time looking more at data and analytics, which we think gives us a little bit of advantage.

So we'll use outside data sources to reinforce some of our views. So we'll look at like credit card. data as an example to essentially be able to get confirmation on trajectories of everything from cable TV spending to retail spending to consumer spending. And we feel like that gives us a real-time edge on a weekly basis, which I think a lot of people don't look at. And then the other thing that we do is we're very disciplined. We don't, which is hard to quantify, but we believe enterprise value is. I think a lot of investors will stretch for yield. And when they stretch for a yield, that can be very, very expensive.

And so what we will try to do is we basically, we don't want to sacrifice enterprise value coverage and we try to avoid permanent impairment. If you look at what credit investing is doing, there's an asymmetric risk profile, bonds are issued at par, and we want to avoid mistakes. And that's something we've been able to do at my time in Artisan. It sounds like there's a mixture of quantitative and qualitative elements to the analysis.

Since I'm such a biased quant, I'm always curious to know what the key factors are quantitatively, maybe like the table stakes, if you will, for you to consider something. Like, is there a minimum level of criteria before you even begin to look at something? And if so, what's kind of the spirit of those criteria? As you look at credit investing, there's a broad suite of industries. I would say that there's a little more of a focus in the market on old line businesses. So if you look at some of the areas, like, for example, energy is roughly 25% of the entire market.

under 25% if you include E&P, MLP, and oil field service. And if you look at those businesses, they're okay businesses. However, if you look at their ability to incur leverage, I would say that's very different

than a software business. It's very different than insurance brokerage business because you don't have that same degree of cyclicality. So as we look at, and you look about the high-yield market historically, the biggest sector in 2005 and 06 was autos. tremendous amount of cyclicality. And if you were to take a quant approach and just say, I'm going to look at leverage debt

to EBITDA and then look at spreads and determine, you know, what the spread return of leverage is as a quant metric. That would have been a very painful experience because you would have underpriced the cyclicality in that piece. And when you had massive swings and profitability, leverage spiked. And there was significant apparent. in those sectors if you just use a purely quant approach from a debt to leverage, which is probably the key metric that most people look at. So I think there's, I think there's an art to it,

as well as a science to it. I think you need to have both, in my opinion. And so that's just because partly because of the nature of the businesses. Interestingly enough, in the credit space, there is some inefficiency. And when artisan, one thing, Arsson was attracted by the space is the ability for active manage to provide value. And this is one of the few spaces where active managers actually beat their passive peers, which is actually, actually I think it's a very interesting dynamic that occurs out there. And that's partly because of the inefficiency that happens from the Nellis perspective. Maybe you could talk more about the driver of that. So in the equity market, you've got cap-weighted indexes. Maybe begin by talking about what the benchmarks are in high

yield and what the largest structural flaws of those benchmarks are. So there's a little different dynamic fixed income versus equity. So let's start out. If you have a benchmark that is tied to market cap or in this situation be total debt, if you have, there's a little bit of a different incentive system on equity having great market. Big market cap is actually very positive. Sure.

Dynamic. If you have a lot of debt, that's obviously not a very good outcome. potentially. And so having the most amount of debt in being overweight that can make you more susceptible to default risk all else being equal. So that's one dynamic. Two, but if you get the ETFs, interestingly enough, the way they're constructed, they try to avoid some of those areas. And they'll try going a little more high quality, but it doesn't always work out that way. And the other components I would say is if you look at ETFs, they have in the space in general, they've underperformed for a few reasons.

One is the fee differential is not as big. Two is transaction costs are much higher for fixed income investing versus equity where it's almost free to trade. And three, there is some inefficiency. There's 1,600 issuers in the high yield market. And so through credit analysis, we can basically find an opportunity. is out there and take meaningful stakes and have the meaningful effect our returns as active managers in general. You mentioned this idea that I really like about lending against cash flows versus asset-backed lending.

And you already mentioned software. So obviously, you know, really great cash flow businesses. I'm curious how that translates into your own thoughts on portfolio construction. So if the benchmark is kind of peculiarly constructed due to what you just described, what groupings do you think about in portfolio construction? Like, are there different takes on this market on the loan and high yield markets within the portfolio? And how do you think about allocating to those different groups, assuming that like this cash flow idea might be one group? So everything we invest is corporate.

So we don't do any structured product. So we tend to look at the underlying businesses. And so as we look at the businesses, cashful lending is obviously something that it sounds very simple. But it's like if you've got the cash flow that service the debt that reduces our risk, we internally tend to bucket in three criteria. area. We look at Core, which think of as a stable, predictable business. An example, that would be like a charter communications. We don't love the cable business, but we really love the broadband business, which does well regardless of the over-the-top threat. Can you just talk about the difference there and why that preference? So if we look at the cable TV business, it's really kind of, the cable

business is basically a commodity type product. So you're basically repackaging various channels. and we personally believe there is some advantage that the companies do have in terms of lower contact costs relative to the YouTube or Hulu just because they purchase more of it. However, they tend to have skinnier bundles and younger viewers particularly don't really want as much. They don't need 150 channels. So there is definitely a loss incrementally of basic TV subscribers. However, in order to access the YouTube's, the Hulus of the world, you need a broadband connection. And the broadband connection, the cable solution is by far most robust solution versus DSL. And so we think there's continued pricing power that those businesses have.

And the margin structure is such that you really have very limited cost. Your margins on high-speed data, they're not broken out, but we believe they're close to 70% EBITDA margins. which are very high, and the cable pay TV margins are actually materially lower because you have to pay ESPN and the content providers for all the product out there. Sure. Sure. So that would be an example of a core. Recording. Spread tightening is an example. We're trying to find a cyclical out of favor company. So it could have been energy when oil was down. And we're basically, we have a view that the business can sustain itself through the downturn. And if there's a macro recovery or company specific, we believe it will have material spread tightening. And in some of the, depending on the risk, you know, it could be high single to 30% IRAs or underwriting depending on what the market environment is. So it can be equity plus returns for taking fixed income risk. Another example to be some of our insurance brokers and our cable, our insurance brokers and our software assets

where the leverage point starts out high today. But as you look forward through cash flow, the ability to de lever meaningfully because of their strong cash generation ability. Are those that, so the spread tightening and the core, those are the two kind of primary? Those are the two primary. And then a smaller component would be a, we have an opportunistic sleeve. The market has been not very volatile. And so we tend to take advantage of opportunities across cap structure. So we'll take advantage of technicals in either the loan or the bond market or we have an

of an event-driven trade. We're a potential covenant violation due to market conditions. It's been very limited. It's a very small part of the portfolio. However, it's added value throughout a cycle. You've referenced spreads quite a number of times. So maybe define what is interesting about spreads, which ones you look at, why they matter and what they tell you about what's going on.

So if you look at spreads, spreads, if we look at simplistically, what are spreads and what do they mean? spreads are what investors are being compensated for taking the credit risk. And so it's return in excess of the treasury rate. And if you have a high-yield bond as an example with the seven-year maturity, and for simplicity, I'd say that the treasury is roughly three and a quarter percent. It's a little higher than it is today. And if you're getting seven and a quarter percent return,

you gain 400 basis points of incremental spread for that risk you're taking. And if you look at the market in aggregate, if you assume spreads are roughly 350 basis points, you're getting 350, 3.5% over the market, treasury market yield for taking that risk. Defaults are your biggest cost of that. And if you assume the market has a 2% default rate, which is actually higher than it is today and higher than expected, what it will be in 19 and 20. And if you assume a 60% loss in defaults, you should be getting paid 120 basis points for just pure default risk. And so spreads are a discounting mechanism for expected future defaults and what you're getting paid for that.

And there's also a liquidity component because investors should be paid an incremental value for not having treasury type risk. So depending on the market conditions, they deviate right now spreads are at historically are closer to the tighter end of the range. And part of it is for good reason because the fundamentals are constructive today. defaults are benign and expect to remain benign. And that's kind of where we are in today's market. Talk a bit about the ratings of these different issuers or the individual issues and how that, maybe what efficiencies lie in that process, whether or not you think rating agencies do a good job or not.

And whether or not that's a source of advantage. So as we look at the agencies, we think they're terrible. I mean, just to be totally blunt about it across the business. board, there's been a lot of validation to that argument over time. You can go back and look at 10 years ago. EIG was AAA risk months before it essentially need to get bailed out and going bankrupt. And AAA risk is supposed to be as good as it gets. A fortress. The fortress. The structure credit market, all the AAA debt that essentially went to zero, your CDOs and CDOs squared. I mean, it just gives you an example of areas where they've been off.

Even within credit, which they're arguably better than structured credit, there are some inefficiency. So there have been companies, for example, in the energy space that we had that were actually underrated, in our opinion, because of a couple of characteristics that they focused on, such as like length of business has been around, which we think has nothing to do with the asset quality. Let's just look at like within a sector. So if you'll get energy as an example, they overrated, diversified companies. companies had scale and they underappreciated cost structure, which if you're in a commodity business, cost structure is your primary driver if you're going to remain solvent. And so companies that were in low cost basins, they were only in those low cost basins had shorter operating history such as the Permian were underrated. And we were able to identify companies that were

upgraded when oil went from 100 to 30, which is kind of ironic. Well, they were downgrading assets such as like Chesapeake that were very diverse in those bonds that end up going down 90% but they were in double B. So it's like you have a lot which presents an opportunity for us as credit pickers because we're able to identify companies where they're just off. How much of the opportunity arises because of a change in rating? So if you look, I think there's a lot of topical things we can talk about on that. So there's about $5 trillion of triple B debt. and where the biggest opportunity is is typically when issuers drop from investment rate to high yield.

Because typically what you have is investment rate holders that are essentially required to either outright sell or materially reduce your exposure. Because if you're an insurance company, you can only have so much capital that's double B or below. And so in that situation, you have force selling and you have opportunities to take advantage of that. If you look broadly what you're seeing is triple B issuance has absolutely exploded over the last five years. As issuers have taken advantage of low rates to either return capital shareholders, do M&A that's debt financed. And if you have a cycle or a cycle within a cycle like you had an energy in 2016, you can expect some pretty material. downgrades in those sectors or broadly across the board. And so that could create a strong buying opportunity.

And where there's probably the most vulnerability is in the longer duration part of the market. Because if you get the investment grade market, the investment grand market tends to be a longer duration market with the average duration of nine. I'd contrast with the high yield market that's given or take three to four years. And so there's an unnatural home for a lot of that paper, 20 to 30 year maturity paper. in the event of downgrids. Maybe you could give a recent example. I always think these processes are best illustrated through an actual company, an actual

issuer. A recent example of something that you came across that you found interesting, maybe the source of what you view as the mispricing. So what we're all trying to do is active managers is identify mispriced securities. So the source of the mispricing, maybe like the high level work done to verify that it might be interesting and then how you thought about actually getting involved. A good example of something that we identified. So there's been some weakness in cyclical type industries as rates have moved up over the last, I don't know, nine months, give or take.

And one of the areas that has underperformed has been housing-related bonds. And there's a company called Beacon Roofing. Beacon Roofing is a roofing distributor. Most of their business is actually not new construction-related. it's predominantly repair and remodel where it's your roof leaks, you need to replace your roof. And incrementally what drives demand is when there's hail damage. So if you have hail damage, you're forced to replace your roof. It's paid for by the insurance companies.

And the company performed a transaction about 12 months ago where they bought with their competitors. It was a debt to finance transaction. And they used high yield bonds to consummate that transaction. When they came with the transaction, the bonds were low coupon, four and seven, eights, and that was done in basically October of last year. We actually thought the valuation was very expensive, but we liked the asset. Between a combination of concerns about interest rates and then interest rates slash housing, and then also concerns about storm activity being less robust than last year, which is factual, the bonds dropped basically, 14 points. And as we look at that, we identified the name through a screen. And the bonds now are yielding roughly. We assume the company takes the bonds out two years before maturity. And it's just under

8% to that date for what we believe is part type risk. As part of our research process, we obviously did financial modeling. We also talked to management. We also talked to competitors, former employees as part to really triangulate how the integration was going in the acquisition. And then we also used, we actually did some interesting proprietary work on the data side. So we actually track every storm that's out there and every hail storm and we're able to quantify it by zip code. And then we overlaid every location. And then we looked within a 20 mile radius to see what the activity was because their footprint is a little different than some of their peers. Try to figure out what the implication was.

from the storm activity and use that as a proxy to see to get confirmation in our views. The storm activity will be better than market expectations are, and that's something we did to really kind of get an edge in terms of that investment. As we look at the business, we think the bonds are roughly 89 cents on the dollar, and so we think that's a very attractive IRA. We think that probably default is very, very low. The company generates meaningful free cash to debt, and the primary focus of the company is to de-leverance balance sheet because that will, and we're aligned with the equity because that will

help their equity value. So that's an example, something we accumulate a material position in the portfolio as a way. And that's something that we identified. Yeah, really interesting combination of triggers and data confirmation and things like that. If you had to identify in your world, like what the most valuable data sources or data sets tend to be. How would you think about that? So as we look at our process, there's a number of,

pieces that I'd like to break it down. First is the ID identification. Unlike the equity world, there are, you know, there's roughly three times the amount of companies in this market relative to the S&P 500. So you have to have a good way to really identify the opportunity set. The good news is that the opportunity set, the return profile is much easier to model because it's mathematical as opposed to as psychological where multiples can be whatever they want in the equity world, you know, we have fixed upside. It's where we'll identify our opportunity

set very quickly through. And we use tablo, which is like a, which is a great visualization software that is able to slice and dice the indexes. That's, that's the first piece that we do on the data side. And then everything that we do from a data source is really more bespoke. And so it's, it's really good. Or idiosyncratic specific to the company. Correct. So it's really trying to track storm data as an example. Another idiosicratic area would be like theaters where we track literally every weekend the box office. Then we can track like what the major movies are and then to see like what drove performance.

So for example, in Q1, Black Panther drove the box office in that. We can see it was 30 or 40 percent of the box and like, you know, what's likely to repeat itself. And we can use data to really kind of track updates on a weekly basis for us automatically. Yeah, it's an interesting advantage if you think about a data edge as being. idiosyncratic versus like something cross-sectional that that's just harder work to scale, right? So it is. Someone like me, it's I can't go get like custom data sets for every individual equity and track that maybe I could with ridiculous resources.

But it's very hard to do. And not every industry has got readily available data out there, but there is, there's a lot of data out there that I don't even think people realize exists. What are some favorite example? Census data is got great data for example. So one thing we're able to track as an example is. very, very interesting is a vinyl siding data over time. You can see how many houses have vinyl siding in like the mix over time. You can track it or there's like a vinyl siding institute, which I guess

there's associations for everything where they basically track squares of shipments by year. And so you can get some pretty good insight as to like how the penetration of that product's gone for years. And that's the sort of things that we look for. What is your favorite part of this whole process? My favorite part is always learning new information. you're always like evolving and it's you're always learning about new businesses. I'm a very competitive person. And the other piece is trying to get an edge relative to our peers and kind of pushing ourselves.

Because if you look at active management, I mean, active management's changing a lot. And you have to evolve your process because if you don't evolve your process, I mean, it's just getting more and more competitive. And so it's really trying to find those next, next pieces that I think will, you know, continue to give us the edge and the moat. So I'll ask an example from each of those categories. So maybe in the last few years, as you're learning new things, what is the most surprising new learning? Probably the most surprising learning is how companies are very good and bankers are very good at manipulating data.

So when you actually go and look at the underlying data, the cherry pick. It's not really surprising, but it's more just reinforcing like how they're able to cherry pick and manipulate charts to make it look different than a broader sample. it's just more just the level of dishonesty. It's probably the more, it's probably the biggest. I mean, obviously, I think that leads into the second, which is like source of edge and evolution. So you mentioned, it sounds like for a long time you've had this idea of cash flow versus assets.

Correct. I'm curious, does the market get wise to that? So if that's a really successful way of thinking about things and maybe that means you're overweight software, you know, markets are usually pretty good at updating their beliefs. So like, how is that edge evolved or changed? And maybe how do you begin to move away from that? it has evolved. It is starting to evolve a little bit. People are getting smarter on it for sure.

I guess I would say is I think of evolution. I'll give you a sense of like how I've evolved as an investor. So we started out, I'm dating myself, but I started out pre-regulation FD. And regulation FD was when companies could basically tell you whatever they wanted and then to put pressure releases out. That changed in 2001. And the edge before used to be having a good relationship with management and being able to kind of anticipate what's going to happen. because they would basically tell you before it was like broadly known. The second evolution, it was essentially having greater independence. And so great independence would be training what's going on through talking to competitors,

former employees, suppliers, and so we do around 150 calls a year with those types of people that really give us an independent view as to what's going on. I think the third leg is essentially using data and analytics to essentially get confirmed, and greater context as to what's happening. So I think that's kind of evolution of our process. I think you need to be, I think you need to, we'll see what's coming next, but I think we're still early in the third phase. And I think a lot of investors actually, particularly on the credit side, aren't even

at the second phase. I think a lot of those investors are focusing on what management's telling them, what, what's in the road show. And it's, it's a more simplistic type of research process. I'm just always interested in structural stuff. You've already mentioned maybe some issues. with the rating agencies, the idea that many investment grade holders or investors are forced to sell under certain conditions when ratings change. Are there other interesting, like,

structural things that drive prices and behavior in this market that you watch closely? Those would be probably the two big factors that I see out there. I guess another way of thinking about this would be. So if active managers are, let's say, the weighted averages they're in step two of that evolution. Not even. Or not even. Not even. The primary, you know, I'm always interested, like, who's on the other side of a trade, right?

Like when I'm buying, like, who am I buying from and why? And sometimes those motivations are pure and they make sense. And sometimes the person's making a mistake. And like, there's only so much investor error to go around. And so I just always want to know, like, what are the pools of investor error? You could argue, you know, for selling because of a dumb rating agency, changing a letter is a source of investor error. So I guess the better way to ask the question is like what are the biggest pools of error and what drives them? That's a good question.

So in terms of investor errors, I never heard of the letter changing, but that's interesting way to put it. It's true, though. I think part of it is if you look at the high yield side, when assets come from investment rate, it's just pure technical. Where you have investors basically have to reduce exposure because of a change of downgrade. And there's a structural reason for that because those investors, essentially are forced from a capital perspective to have only have X number, they have to have X number of reserves depending on the rating criteria.

And it just is what it is. In terms of within the high yield side, if you look specifically what we're doing debt that is lower rated, some investors preclude themselves from Biden lower rated papers such as triple C paper, where they have specific limitations that they can only own X percent. And we tend to look at where we believe the trajectory of the credit is going and what the, what we believe the credit metrics will, we expect them to be improving, which is a very

different opinion. You have to understand like why companies are rated lower quality. I think a lot of investors will say, oh, it's triple C. I don't want to own it. And if I can own triple C, I want to get paid greater, you know, greater yield for that because it's, you know, it looks bad on my fact sheet to have that exposure. We look at it and if you, we look at it, we say, what's the trajectory of the business? What do we think leverage will look like? What do we think the equity value creation is? And are we aligned with the equity from a business strategy perspective and how we see the business evolving, the balance sheet evolving. And so that's how we tend to think about it, which is a little more nuanced. And so in general, if you look at some of our lower quality paper, the yield is

generally less than that of that subsector. But if we look at the trajectory, it's obviously going forward. And we think that's kind of it's, it's an arm we're able to capitalize on. I'm always fascinated by industries. And I don't want to talk about software because we've talked about that little bit. What couple other, maybe two or three other industries and maybe we'll leave cable and broadband aside as well. So trying just to identify some other different examples, do you find most interesting for your work right now? It really kind of evolves. We have an opportunistic been to us. And so it depends where the opportunity has been. So we, due to the environment, we went from essentially zero energy weighting in the middle of 14 to high teens

energy exposure. And so we thought that was actually a really interesting time because you had an environment where the price of the commodity was basically unsustainable, where it was from a reinvestment perspective and we're able to identify names where we could get 20 plus percent IRAs because of that fear of the price that underlying commodity. And we're also able to extend in different areas, which that was actually more interesting. So we were able to extend it into MLPs, which there was concern about the solvency of some of their counterparties in combined with leverage, answering to buy some investment rate assets between single B and triple C valuations. And then we took it even one step further.

It went and found another place such as Gardner, Denver, which had around half their business exposed to supplying basically components to the energy space that had the drop off with E&Ps essentially reducing their spending. So that was an area that I thought was actually really interesting in the energy space and it's something that we aggressively added to risk when it was downed and were able to find great opportunities that we got a big cyclical recovery. Another example that we saw after that was retail sold off, and it was kind of a continuation of the obvious trends that people see out there, such as online. And then there are a couple names like Jay Crewe and Neiman, which have meaningful online exposure between 35 and over 50 percent.

Their business is online, but it was kind of, they had company missteps that we believed were going to reverse themselves. That played out in basically 16, 17 time period. I'm sorry, 17, 18 time period. And then recently it's been really the part of the market that's probably that we thought was the most overpriced, the highest quality part of the market, which is very interesting because investors perceived the higher quality is being more defensible. And it was actually the most vulnerable. And it was the most vulnerable because it had the most rate sensitivity.

And so you saw a number of those companies with long duration sell off the most. And so we actually found that as an opportunity as we were like that area because we saw some of the excesses. And we actually moved a lot of our higher quality into more flooding rate paper, which was immune to some of those risks. If you were forced to leave the high yield market, what other market do you find kind of next most interesting? If I were forced to leave the high yield market, I probably would just leave the business. That would be that would, I mean, I love what I do. And is that a reflection of the relative opportunity set? You know, you think you've identified a place that has inefficiencies that can be taken advantage of consistently.

Am I reading too much into that that you think that? No, no, I wouldn't read that much into it. I mean, I love the high yield business. I think if it was a situation, the way I'm personally wired, I'm all in or I'm out. And so if I'm out, I'd be retired and I would do something with my, you know, spend time and tired with my family and my kids. So that's what I would do. So I'm in or I'm out and I'm in. and I'm not someone that's going to be like half in.

I'm not going to, I found my calling. I'm sticking with it. And if I'm out, I'll be on the beach somewhere. You mentioned or referred to a healthy skepticism, I'd say, kind of throughout the conversation. I'm curious to what degree you've gotten more skeptical of just things in general, companies. You mentioned bankers, rating agencies, et cetera, as your career has progressed.

I think it's natural when you start in the business. You have this view that everyone's here to be honest and tell the truth. And then you learn through experience that incentives are not aligned. Issuers want the lowest cost of capital. And so often they'll tell you what they need to tell you to drive that cost of capital down. And so we have bankers on the other side are working for the issuer. They're not working for the investor. We're fully aware of that.

And so that's why we think the value of independence is very high. And so that's why we are totally independent. We don't really care what other people perceive. That's why our portfolios look very different. than the benchmark and most of our peers. A selfish question as an equity guy and always interested in whether or not we can triangulate other things about a business versus what we would normally look at. Are there factors that you would say portend very bad future things happening on the equity

side based on work that you do on the credit side? So like I'll give you an example, just based on talking to you what comes to mind. So maybe if the cost of capital or new issuance in an industry is rising, let's say. maybe that is a negative, all things equal, a negative factor for the future returns of the equity. Absolutely. So I'm just curious, things like that. If there are other ideas that you think might be interesting to the equity investors out there. If you look at fixed income and credit in general, if your cost of credit goes up, it's a disaster for equities, broadly speaking. So it's absolutely important. And the implications are across the board. If credit costs are very high, if rates are

expensive. It's very challenging for companies to want to invest to grow. They can't spend capital expenditures like they used to. And so it's actually got a very negative real economy connotation. So when you came out of the financial crisis and the average high yield bond was yielding 20%. It was uneconomic for any company to incur debt to do any sort of capital project. And so that partially the flow through the economy is very real in that scenario. If you look at other sets, sectors, when they lose access to capital, the knockdown effects are very real. And so if you go back to the latest crisis in like the energy space as an example, if E&Ps, if their bonds are in the 40s or 50s, they have no ability to issue new capital. They can't grow production. They're likely shrinking production. And then there's there's kind of layoffs across. There's layoffs. There's companies are just trying to repair their balance sheet. And there's no chance of any sort of value in return to equity holders in the form of dividends, share repurchases. And so the credit side is something to be very careful. Credit tends to be early cycle.

It tends to lead equities in general. And if you saw in the last downturn, you saw credit underperform pretty dramatically before equities did. And that makes sense because credit is more focused on downside, where equity is more of looking for what the upside, more focused on upside. So I think those are some pretty interesting dynamics that happened. If you had to sum up a lot of these concepts that we've talked about today,

you know, spreads, et cetera. what are they telling you about just kind of the broad picture today, what the world looks like today relative to the past? So if you look at October as an example, when there was a lot of equity volatility, credit was off marginally, but it was off about a percent and a half. So the implication there was it's not a systemic. This is not like another recession. So there wasn't as much concern in the credit market, nearly as much as there was in the equity market. A lot of the equity market, though, a lot of the downside was really concentrated some very high multiple gross stocks that had massive upside moves in the prior 12 to 24 months. And we just don't have

that same dynamic in the credit markets. The credit markets are clearly very robust now and they're strong in it. And they're not sensing or pricing in any sort of like economic deterioration. One of the things that I forgot to ask earlier is like the notion of covenants, how much you track. what are the major categories of covenants that you care about? So I'd like to ask that question first. And then my second question will be like whether or not there's anything that seems scary to you today. So just to give you kind of where we're going.

But first, on the covenant side, what do you care about? So let's talk about what covenants are because I think it's probably a good level at point. So covenants are, it's a one way promise the issuer makes to the lenders in terms of what they will do in terms of one, what's called a maintenance covenant, which are profitability levels the company must sustain. And then two, there is also incurrence-based covenants, which allows the company to incur debt as long as they meet certain ratios.

And there's been a lot of attention about covenant light. And covenant light is tied to the maintenance of certain profitability levels, and that is essentially gone away. And that's in the loan market. It's around 85, 90% of issuers now are covenant light. And I think it goes beyond that. are essentially power that either the issuer or the investor has in terms of if there is some sort of issue or a covenant problem, basically the bondholders or the loanholders essentially have

the ability to renegotiate with the issuer. And so issuers have basically tried to take as much flexibility of that power. And it's gone to themselves. And part of it is because of the structural change in the market, which we talked about earlier, where the market used to be a syndicated market. I'm sorry, originated market now it's a syndicated market where investors like ourselves own it

and we can try get leverage over the issuer. But it's actually gone one step further. Now issuers have created docs or even looser and they've got the ability to transfer value away from creditors in certain circumstances. What would be an example of that? An example of that would be Seizers was an example where they moved collateral.

J. Crew moved collateral. out of the group. And then if you look at PetSmart, they bought Chewy. They actually used some of the Chewy Collateral. They were trying to strip that away from the group and basically move it into a different entity that will allow them to either give that value to equity holders or else capture discounts in their bonds by allowing subordinate bonds to exchange into that collateral and reduce principal balance.

So I think in the next downturn, that will be that will be something that we're very aware of. We never buy an issuer based on covenants, but it can prevent us from buying one. Typically, the higher quality companies have the loosest covenants, which makes sense because they've got availability and probably the museum's less. As we go going forward, we're going to spend, we think there'll be transfer value between different credit groups. Another example of where issuers use this as in the downturn. Companies would take subordinate capital in exchange into more senior capital at a discount.

So Chesapeake did it. it as an example. California resources did it as an example in unsecured creditors were essentially allowed the opportunity to move up in seniority at oftentimes, you know, 50 cents on the dollar. And so it's a pretty clever way for the issuers to capture discount. And if they reduce that debt balance, so let's just say you take a billion dollar of debt exchange of 50 cents on the dollar, you've essentially reduced 500 million of debt if you're the issuer. So what does, if anything, have you scared or at least hyper aware in? in high-yield markets today. In terms of high-yield, we're always looking for what can go wrong.

I mean, that's the whole business. What we're looking at right now is, I think the biggest question in the market is what happens on the issuance front and how will we progress through the cycle. And typically, you'll have risky issuance and risky issuance is kind of a precursor to future defaults. And what we're monitoring is basically that leveraged biode activity. It's been relatively light, especially if you consider the amount of capital that's been raised by private equity firms, it's been raised but not deployed. So there's been about trillion dollars of PE capital that's raised but not deployed. And as that capital, if you assume a roughly a 30%, 35% equity investment, that's potentially $2 trillion of debt if it all goes in the U.S., which probably about half of it

will go. But is that, and we're going to look at the terms, look at covenants, we'll look at the overall issue of quality and try to see, you know, how the cycle progresses. And thus far, it's been relatively light. And that's been kind of the big surprise is there's been this lack of private equity, LBO activity, concerning the amount of capital pools that have been raised. I think a lot of it has to do with the economics are challenging for the Piqui side to make it work on the buy outside. Well, this has been fascinating. My closing question for everybody is for the kindest thing that anyone's ever done for you. I would say, not one particular thing, but I'd say in general, I'd give my wife credit. She raises our three kids.

and it's been really, I think it's been a sacrifice on her part to make sure that she is a good influence, raises our kids, and allows me to basically work and do what I do. So it's probably been the kindest thing that she's ever done. Wonderful. This has been a whole new area for me, so I appreciate all the learnings, all the insight and all the time. Thank you. Appreciate it. Hey, everyone. Patrick here again. To find more episodes of Invest like the best, go to investorfieldguide.com forward slash podcast. If you're a book lover, you can also sign up for my book club at investorfieldguide.com forward slash book club. After you sign up, you'll receive a full investor curriculum right away, and then three to four suggestions of new books every month. You can also

follow me on Twitter at Patrick underscore Oshag, OSHAG. If you enjoy the show, please leave a quick review for us on iTunes, which will help more people discover Invest Like the Best. Thanks so much for listening.