Bottom Up Credit Analysis

One of the primary tools used at Stamper Capital & Investments, Inc. to make investment decisions is bottom-up credit research. Credit research is especially important when investing in lower quality or high yield bonds. The major concern when making investments in lower quality bonds is that the credit quality does not deteriorate and that you are paid back principal and interest on schedule. Purchasing high yield bonds is a lot like making a loan. There are numerous variables (see below) that you look at to make sure you are going to be paid back. Once a position is analyzed on a credit quality basis, its potential return is compared to the credit quality of the investment and the risk of something going wrong and the downside protection if it does. Importantly, you want to get a superior ratio of expected return and upside potential per amount of downside risk - determining if the investment is worth making.  We have found that one of the keys to superior risk-adjusted performance in high yield investing is avoidance of certain situations (which are reviewed below).

Worst Case Basis - One of the most important aspects of credit quality analysis is to analyze an investment on a worst case basis. You want to understand what would happen to the investment under a worst case scenario where everything that can go wrong does go wrong; bankruptcy, for example (however, there are often low risk investments in bankrupt securities if you know how to analyze the upside potential and downside protection of the investment).

SPECIFIC CREDIT QUALITY FACTORS TO CONSIDER

Cash-Flow Coverage of Interest and Capital Expenditures - We look at how much an issuer’s cash flow covers its interest expense as one of the most important credit factors. This ratio is computed for the issuer and compared for several different periods (this year compared to the same period last year, for example) and to the ratios of the competitors in its industry. What might be considered adequate for one industry might be considered inadequate for another. The most important aspect is that the issuer’s cash flow generation can support its debt in the form of interest expense and principal payments. After that, it should have enough left over for capital expenditures so that the underlying assets are maintained and not depleted.

Asset Coverage of Debt - Looking at the asset coverage of debt is another way to see how much downside protection you would have as an investor.  For a company with publicly traded equity, this calculation is fairly easy (since the data is supplied independently by the market). By simply adding the market value of the issuer's equity plus the amount of its debt, divided by the issuer's debt an investor can find out how much downside protection they have in his or her investment. With a private issuer, the market value must be estimated using historical comparables - with the same calculation previously listed for public companies.  If the bond is secured, an investor can look at the value of the collateral backing the bonds compared to the amount of secured debt. If the ratio is high, the bonds are well covered and the credit quality will be stronger than if the ratio is lower.  A similar technique used over the last couple of years to calculate an issuer's "leverage" is to use the outstanding long-term debt divided by the annual cash flow.  When using this "leverage" figure, the lower the number the better - it can also be compared to that of competitors and to industry averages.

Cyclicality of the Business - The cyclicality of an issuer's revenues and cash flow can be used to measure the  up and down movements with the economic cycle.  When the economy is doing well, such a company does well, but when there is an economic downturn, the company’s performance declines along with the economy.  In short, the more cyclical a company, the less room there is for error and therefore there should be less allowance for financial leverage on debt.

Appropriateness of an Issuer’s Capital Structure -  If a company issues long-term bonds to fund what in its industry is traditionally working capital, a long-term investor in those bonds will almost certainly under-perform due to credit quality problems.  The appropriateness of an issuer's capital structure to its underlying business is very important. If the assets and liabilities are not properly matched from a financial and business viewpoint, the downside protection of the issuer's bonds may be in jeopardy.  A more specific example would be the home building industry.  Most of the capital in this business is for developing land and building homes.  However, some home builders are financed with senior secured working capital and with other long-term unsecured bonds.  In reality this long-term debt is really working capital - and it should be secured since working capital is almost always secured by the short-term assets it is financing.  The bonds in this example are part of a mismatched capital structure that is headed for disaster.  The financial structure is mismatched because long-term debt is being used to finance a short-term asset, new homes.  Banks would only lend that money on a secured basis.

Position in Capital Structure - Companies often have several types of debt outstanding; secured bank debt, secured bonds, senior unsecured bonds, senior subordinated bonds, subordinated bonds and junior subordinated bonds.  The amount of bonds senior and junior to a particular issue can affect that issue's downside protection.  For example, if an issuer has what seems to be a reasonable amount of overall debt but most of that debt is secured by all the assets of the Company, the remaining subordinated debt is probably a lot riskier than it appears on the surface.

Often businesses are structured to consist of separate companies: an operating company where the issuer's assets are held and a holding company that includes additional financial structures. Generally, the operating company securities are less risky than the holding company securities.

Maturity Schedule - Looking at an issuer's debt maturity schedule to see how soon and how large its debt maturities are, especially in relation to the issuer's cash flow, can be an important decision making factor.  If large maturities come due soon, the company may have some refinancing risk.  If money is tight, then refinancing pressures could cause bond prices to drop.  Small maturities do not have as much refinancing risk as long as there no big maturities ahead of them.  Thus, some bonds of the same issuer might be substantially safer than others even though the yield is similar.

Owner and Management Track Record - Management and owner/sponsor track-records should be reviewed in two ways: how well they run companies and how well they treat bondholders.  Management should have a good track-record with a reputation for increasing the value of the business and/or turning around businesses situations. The management should have experience in the particular industry of the issuer.  Unfortunately, some owners/managers, in order to increase shareholder value, will try to take advantage of the bondholders. Investors must be very careful when dealing in securities of a company with a management that has this type of reputation.  However, bonds of an issuer whose owner has a reputation for abusing bondholders often trade far too cheap and offer interesting investment opportunities.

Incentivized Management - When a company ties the compensation of its managers to the performance and value of the company, the managers tend to pay closer attention to the performance of the company.  This is good for the value of the company and for the bondholders.  An example of incentivized management is employee-owned companies or companies that give employees stock options. Another example is bonuses tied to cash flow generation targets or expense reduction targets.  Paying attention to whether the compensation and incentives of this type are only connected to the company’s top management, or if other levels of management are also tied into the incentive program can also be important.

Low Cost Producer Status - Being a low-cost producer generally provides extra downside protection for a business and its bondholders. It gives more room for the business to maneuver. Having low cost producer status will usually give the company a wider profit margin and make the company more attractive to potential buyers; thus providing downside protection.

Discrete Salable Assets - Some companies have operations that can be separated into discrete business units. In this case, a company’s distinct assets can be sold to raise cash if and when needed.  This provides the company with increased financial flexibility, giving the bondholders additional downside protection.

Leading Market Share Position - A company with a leading market position is attractive for several reasons. In such a case a company generally has better economies of scale and higher profit margins. These attributes give it increased financial flexibility and also make it more attractive to potential buyers, thus providing additional downside protection.

Barriers To Entry - Defendable Markets - Companies in industries with barriers to entry are generally less susceptible to risks of competition. Thus, an established position in this type of market will increase the value of the company to potential buyers, and increase the downside protection of the bondholders.

Avoid Fad Businesses - Fad businesses are usually very risky for bondholders.  While the upside of a successful fad business can be good for equity investments, the bond’s upside is limited by the call.  On the other hand, the downside risk is substantial because fads usually swing out of favor.  Bonds trading at a deep discount price, if available, can make sense in this area.

Avoid Businesses Without Real Assets - Businesses without real assets such as marketing companies, distributors, and wholesalers have the risk of going bankrupt and there may be nothing of real value left.  If a company of this type is attractive and you want to pursue an investment of this type, a better play would probably be in its equity securities or its convertible bonds if they are trading at a deep discount dollar price.

Well Known Brand Names - A well known brand name can be very important under the worst-case scenario of bankruptcy or restructuring.  History has shown that in financial difficulty, outside buyers are often willing to pay high prices for popular brands.

Covenants - A bond is a security contract. In the contract exist covenants which detail what acts will be performed according to the agreement and which will be refrained from. The covenants are designed to protect the lender’s interests and provide some protection for bond holders. Covenants today are fairly standard.  However, this was not the case even as recently as five years ago, accordingly the covenants should be reviewed to see how the bond holders are protected.

INFORMATION SOURCES

While sell-side analysts reports have improved dramatically in quality since the 1980’s, they are still often slanted toward a broker's trading position and can often be in conflict with your best interests. Therefore, it is still very important to do your own work.  In order to do your own work you need to secure a lot of information.  Most of the credit analysis is going to be done from information contained in a Company’s annual and quarterly financial statements (or their 10K and 10Q) and in the bond issue’s prospectus.  You can also call the issuer and talk to the Chief Financial Officer, Treasurer, Controller, or other management such as the marketing department to find out answers to your specific questions. In addition, most news stories on an issuer can be captured from news services on electronic data machines such as Bloomberg or from the Internet. Newspapers and magazines are good sources for background information on issuer management and industries and Bloomberg is also a good source of security characteristics of a company’s issues.  A review of sell-side analyst reports can be worth while.  But one of the most important sources is the experience of investing in similar types of positions over several years and having contacts on Wall Street that you can bounce ideas off of.