everything has a price
20 September 2018
Most investors systematically avoid struggling businesses – their publicly traded bonds and equity drop out of passive indices, and active managers typically lack the skills, resources or simply appetite to take on managing them. But opportunistic investing is a strategy characterised by targeting under-performing and/or under-managed businesses.
I know what you’re thinking: there is a good reason to avoid investing in struggling businesses – they are struggling! But hear me out…
The key is price
Assets of these businesses trade cheaply, presenting the opportunity for very strong returns. Remember how most investors systematically avoid these markets? Well that helps too, creating an “inefficient” market with lots of forced sellers and not many skilled buyers.
Opportunistic managers specialise in finding the right opportunities in these markets, picking the companies which are trading more cheaply than they should be.
The most typical approach is to buy bonds issued by these businesses, at a deeply discounted price. From there, either the company recovers, and can pay-off its debt in full, or it fails and the assets are sold to pay back bond holders.
This is, though, the most wide-ranging of our asset class categories, and the funds themselves are flexible in where they make their investments, depending on where opportunities arise. Each manager has its own particular niches and specialisms, and aims for different levels of risk and return.
The way we see it, opportunistic managers have at least the following characteristics in common:
- High conviction - building portfolios of relatively few, carefully selected investments
- Fundamental approach - investments are assessed with a detailed analysis of the company’s prospects and value
- Unconstrained - cash-plus targets, not pegged to wider market performance
- Flexible - managers have wide discretion as to where to invest
- Downside protection - considerable focus on underlying security to control losses
As part of the process of considering this type of investment, it is important to consider a range of managers and to find the right ones for your circumstances.
When do these managers perform best?
History suggests that these managers perform strongly when money is invested in challenging economic environments. Given it is so important for these managers to be picky, the more struggling businesses there are to choose from, the better.
The chart below shows the average performance of this strategy one year before and three years after each of the seven credit crises since 1990. Managers typically find ample opportunities after these periods and subsequently deliver strong returns.
Performance of this strategy after periods of credit crisis
For close to a decade now, markets have largely enjoyed a gradual recovery with little in the way of volatility. Should we see a substantial correction over the coming years, opportunistic managers should be well-positioned to take advantage.
What are the risks?
It won’t surprise you that investing in struggling businesses does involve some risk.
The key risk is that managers won’t get every decision right, and lose money when businesses do not recover. Suitably experienced and resourced managers mitigate this by conducting thorough assessments of the company’s creditworthiness, developing a full understanding of a business’s assets, revenues and the potential outcomes.
Managers also have the legal expertise to understand and enforce their ownership rights over the business’s assets, should it come to that.
All of this is time-consuming, complicated and specialist work, so managers tend to charge relatively high fees. Investors will also have to be prepared to lock money away in a closed fund structure for a number of years.
Clearly these risks warrant close consideration. However, I believe that for many investors they can be appropriately managed as part of a balanced overall portfolio.
And let’s not forget the second part of the “risk vs reward” relationship – in today’s low yield environment, the potential reward on offer from opportunistic managers may more than offset the different risks that they bring.
Most traditional asset classes have delivered very strong returns over the past few years. In these environments, it can be easy to sit back, relax and assume all is well with the world. Perhaps Gordon Brown was right all along, and we will never again see the “boom and bust” cycle…
But the events of 2008/09 suggest he wasn’t. Since then, the extended recovery across all asset classes has been supported by unprecedented central bank support, pumping money into the markets, driving up prices and allowing struggling businesses to prop themselves up with cheap debt.
Surely this cannot continue forever. We are already seeing central banks start to move away from these policies, and the impact on inflated markets could be severe. Given bonds and equities have marched up in price together, I question whether relying on “diversification” between bonds and equities will work this time around.
Overall, I believe that opportunistic managers can add genuine diversification to investors’ portfolios, which may prove very valuable over the coming years.