Finding value in each other: active collaboration in equity and bond analysis

 

After a year of unprecedented disruption, we have seen both equity and corporate credit index levels surpass what many investors would have thought possible nearly a year ago, during the COVID-19 correction. In such an environment, and with the trajectory of the global pandemic still unknown, analysing a firm's entire capital structure could be critical to identifying companies with strong business models and sustainable growth opportunities.

Enter active management. Much is made about the potential strength of active management when valuations may not entirely reflect fundamentals. But one aspect of active management that is rarely discussed – and which can be extremely valuable for this fundamental research and analysis process – is collaboration between a firm’s corporate bond and equity teams.

We recently explored how this collaborative process works at Janus Henderson. Speaking with Seth Meyer and Brent Olson, high yield Portfolio Managers, and Nick Schommer, US equity Portfolio Manager, we found there are many more ways in which managers provide insights to each other than we had imagined. We also learned that what it all boils down to is something everyone would agree is essential: teamwork.

There are equities and bonds, but just one company

As Janus Henderson’s corporate research is grounded in bottom-up fundamental analysis, it stands to reason that there is some overlap in the research done by our stock and bond analysts.

Brent: A company typically decides to finance its operations and future growth with a mix of capital: debt (bonds) and equity (stock or shares). Fixed income analysts tend to focus on the appeal of the company’s bonds while equity analysts study the value of its equities. We may focus on different pieces of the company’s financial story, but at the end of the day, we are looking at the same overall company.

While different focuses may lead to different opportunities, sometimes an opportunity passes from one market (such as bonds) to another (such as equities). As Seth explained:

Seth: It’s not uncommon for research done on the fixed income side to eventually evolve into an opportunity in the company’s equity, and vice versa. For instance, bond analysts may be quicker to recognise the impact of a potential debt restructuring. If that happens, a company’s bonds may rally first, but then the equity may subsequently climb as investors weigh the benefits of decreased leverage, better liquidity and an improved credit profile.

So, high yield bond analysts may be able to not only identify an opportunity, but also know when to pass it on to the equity team. Nick elaborated:

Nick: Getting an idea handed off from the high-yield bond team can be a relatively unique opportunity for equity managers. I generally see this when a company’s financial position improves as it deleverages. When a company gets to about a three times debt-to-EBITDA¹ ratio, equity investors may begin to see real returns in the form of share buybacks, for example, and may gain more confidence in that company’s ability to invest for future growth.

¹EBITDA = earnings before interest, tax, depreciation and amortisation.

But such a handoff can, and does, go both ways.

Nick: On the flip side, we may see a company re-leverage, in order to fund mergers and acquisitions, for instance. In a case where we own that specific share, we can use the insight we have built in making the equity investment – like our relationship with the company’s management team – and share that knowledge with the fixed income analysts. This may be particularly useful if the company’s bond credit rating is in flux as a result of any added debt from an acquisition.

Sometimes, the reason an investment idea can be passed between equity and bond investors is not only because they are segregated by convention, but also because different kinds of investors look for different opportunities:

Nick: With a more highly levered business, we tend to see a greater proportion of hedge fund investors on the equity side. They often have shorter investment time frames and are more comfortable with the additional volatility (and return potential) that high leverage entails. But as a company deleverages and strengthens its balance sheet, more cash can be given to shareholders, and a new base of equity investors may begin to look at the company. If you can get there earlier, you have an advantage: you can potentially arbitrage investor bases’ different appetites for leverage and risk. If we can be told by the fixed income team the leverage may be coming down, we may have an advantage.

The value of differing perspectives

While Nick, Seth and Brent were quick to poke fun at each other, they all agreed that – regardless of the opportunity – just looking at the same company or industry from their respective viewpoints added tangible value to the other’s understanding of the opportunity and the ability to find a way to express it:

Nick: In general, equity investors spend more of their time looking at a company’s income statement, while fixed income investors spend more on the balance sheet and cash flow statements. In the case of one company, I was able to understand the liquidity profile better after talking with Brent and Seth, and I saw that they could refinance bonds that would mature in the near term, so I had a ton of confidence in the company’s liquidity profile. It gave me confidence that although the company may have a difficult period, it could get a credit rating upgrade and be a good longer-term investment.

Brent: Good ideas come from the high yield research team to the equity team for two primary reasons. First, we are monitoring trends and progression – both positive and negative – on a company’s balance sheet and we tend to recognise them before the equity market does because it is less focused in that area. Second, it often happens that we have a longer history with a particular company’s management team because they came to us first for financing.

And, predictably, good ideas come the other way too:

Brent: On the other hand, there are specific sectors and industries for which our equity team has deep knowledge that is not as readily available on the fixed income side. We have seen this, for example, in large pharmaceutical companies, which do not have a significant presence in the high yield market. Nick and others on the equity team can serve as a tremendous resource with their in-depth coverage of those areas of the market.

Nick: Kind of you to say so, Brent. And, he is right. In the health care sector, where science is incredibly important, our equity team includes three PhDs. Their insight is invaluable in helping us understand the complexities of various medical devices and drugs. Whereas the fixed income team may own a biotechnology company’s bonds or a convertible bond issued by a large pharmaceutical firm with leverage, I often view myself as a liaison to help them understand the research being done on the equity side.

Seth: I’m enrolling in a PhD. programme. As soon as I finish these jalapeño Cheetos.

Nick: What is it with you and jalapeño Cheetos?

Seth: That is information I am not sharing.

The value of sharing thematic Ideas

Sometimes sharing general thoughts on the economy or social changes can evoke ideas that resonate with a colleague from another department. It turns out that Seth, Nick and Brent are sharing as much – if not more – of their ideas or concerns about various investment ‘themes’ as they are about specific companies. Whether it is the changing role of energy in the US or the impact of COVID-19 on society, these are collaborative explorations:

Nick: Certain segments of the energy sector have been unattractive for some time, in our view, because we believe we are undergoing a generational transformation in how we consume power – away from fossil fuels and toward an increasingly electrical grid-based economy. Through sharing these general ideas with the fixed income guys, we have built our knowledge base and our understanding of specific companies’ balance sheets that they are more focused on. The result is that we have not only identified certain troubled areas (thanks guys) but have also been able to discuss the investment potential in this theme. This type of collaboration proved to be particularly useful during the March 2020 downturn.

At the beginning of the pandemic, we believed that a health solution could enable a return to normal and reopening of the economy. We identified segments we believed could benefit as the economic recovery broadens, like leisure travel and regional gaming. Working with the fixed income team, we sought to better understand changes to company business models and differences in pre- and post-COVID financials to home in on several names.

Seth: It helped us both. Sometimes I had an idea and because of Nick’s knowledge, I was able to flesh it out and find a way to express it in the high yield market, and vice versa. Another example, which may be as boring as it sounds, is aluminium cans. Aluminium is an area that we all believe has long-term secular tailwinds, such as the decline in the use of plastics for environmental reasons, working in its favour. But how to express it? Brent?

Brent: Yeah, I cover several high yield companies in the aluminium space that, although they do not have publicly traded equity, provide us with some data points that are impactful to similar companies that are publicly traded and that have equities. Many of the suppliers for aluminium products, like electric vehicle parts or metal packaging, are high yield companies. They may or may not have equity outstanding, but they dominate a significant part of the aluminium market and benefit from these long-term secular themes we are talking about – the transition to electric vehicles and a decline in the use of plastics. This theme prompted us to come together to share our insights.

Nick: I think the point is that it is iterative. Because I think we arrived at many of these ideas together. The more we talk, the more we understand why the other team owns the companies they do and you start to get more comfortable about asking yourself: ‘why limit ourselves in the way we research companies?’ So, I think that is the process – very iterative, very collaborative.

The value of teamwork

After listening to these portfolio managers from such different markets talk about the value they provide each other, we had to ask: Why don’t more firms do this kind of collaboration?

Nick: They should, but I’m glad they don’t! In many firms, I don’t think the fixed income credit team is working with the equity team quite like we do. I have a great relationship with these guys and am, annoyingly, always picking their brains. But I do help them, too. For example, there is one sector I’ve told them not to own, and when they have listened to me it has really worked out.

Seth: It’s true, and we talk almost every day. I’m not sure there is an independent thought. We will have different discussions within our respective teams, for sure, as we manage different portfolios and different risks, but we’re walking to get coffee together all the time. A lot can be said on a coffee run.

Nick: True. But – even though I say it all the time – for the record: I am better at stealing their great ideas than they are at stealing mine.