Opportunity in leveraged companies

Transcription

1 February 2015» White paper Opportunity in leveraged companies David L. Glancy Portfolio Manager Key takeaways Leverage can create attractive investment opportunities. Leveraged-company securities offer different performance characteristics than the broad stock and bond markets. Leveraged-company investing requires specialized managerial skill for analyzing balance sheets and corporate capital structures. Putnam s David Glancy is skilled in leveragedcompany investing, with more than 25 years of experience. The fundamental and financial opportunities inherent in leveraged companies can provide strong upside potential for investments across their capital structures. Leverage tends to accelerate business changes at a company, potentially increasing returns on equity. Leverage also creates complexity, which makes it more likely that securities of these companies common and preferred equity, high-yield bonds, and bank loans will be mispriced, offering great opportunities to investors who can analyze them correctly. When a company employs different types of leverage from bank loans and bonds to preferred equity shares each type of security can have distinct investment characteristics. Debt can have a variety of effects on cash flow and earnings, which is what ultimately matters to equity investors. The equity of companies that use debt successfully to grow operations can appreciate quickly, particularly during periods of economic recovery when borrowing costs may be low. Investing successfully in leveraged companies requires thorough understanding of corporate finance, accounting, and the intricacies of the capital structure. It takes unique skills and experience to analyze the layers of capital structures and find nuggets of exceptional value. One of the most experienced portfolio managers specializing in leveraged companies is Putnam s David Glancy. He has devoted his 28-year career to investing in leveraged companies and has managed portfolios that invest in leveraged companies over several economic and market cycles. He is fluent in the arcane language of corporate finance and accounting arrangements, giving him the ability to thoroughly dissect corporate balance sheets and fully grasp opportunities and risks. He has had firsthand experience participating in corporate reorganizations that helped to unlock value for investors. This paper provides background on investing in the equity and debt securities of leveraged companies and highlights two strategies managed by Mr. Glancy to pursue current and future opportunities among leveraged companies. PUTNAM INVESTMENTS putnam.com

2 FEBRUARY 2015 Opportunity in leveraged companies Leveraged businesses employ large amounts of debt by issuing high-yield bonds or bank loans, and where successful, this strategy can increase returns on equity and lift the performance of all the company s securities. Defining leveraged companies A leveraged company is any company that employs significant leverage in its capital structure through any combination of borrowing from banks and other lenders and through issuing fixed-income, convertible, or preferred equity securities. Many of these companies lack the operating history or balance-sheet strength to merit an investment-grade bond rating from the major rating agencies. To understand the concept of leverage, it may be helpful to recognize that a home mortgage is a type of leverage. A mortgage is debt that finances the purchase of a home. A homeowner s down payment is equivalent to equity, and the mortgage represents leverage. This metaphor of a mortgage also helps illustrate the power that leverage can have. For many people, a mortgage is the catalyst that makes it possible to move from renting a home to owning one. Similarly, for businesses, debt leverage is like a catalyst that can accelerate changes at a company, allowing it to grow more rapidly and increase its equity value over time. Types of leveraged companies Companies become leveraged for different reasons. The following are common types of leveraged companies: Capital-intensive businesses, such as telecommunications companies, that borrow money to build and maintain network infrastructure. Rising stars, or early-stage growth companies, that use borrowing to finance their operations while they develop new products and a customer base. Many young technology and biotechnology companies have this business model. Fallen angels, or former investment-grade companies, that had been in stronger capital positions but have become more heavily dependent on debt. Special situation companies that use debt as part of a restructuring, or as part of a merger, acquisition, or privatization. How leverage can increase a company s return on equity Why would a company add leverage? A company can generate higher returns on equity if it increases its use of debt. When a company uses debt, its equity holders avoid risking additional equity because the new money is borrowed from others. Any future increase in returns (above the cost of debt service) accrues to the same equity base (Figure 1). Of course, the interest payments that come with the debt add to the company s operating expenses and thereby reduce profits. However, as long as the company s cash flow can cover the interest payments, even a smaller profit margin can result in a higher return on the equity invested by shareholders. Securities of leveraged companies can provide strong returns Leveraged-company equities offer the potential to outperform the stock market by a significant margin, particularly during a period of economic recovery. Since these companies use debt heavily, they tend to have their best performance when credit is widely available, interest rates are low, and strong economic momentum supports business earnings. An example of such a period occurred Figure 1. Leverage can increase return potential to equity investors Capital structure Income Return on equity Company A $200 in equity $50 $50/$200 = 25% Company B (leveraged) $100 in equity + $100 in debt $40 ($50 $10 interest cost) $40/$100 = 40% PUTNAM INVESTMENTS putnam.com 2

3 PUTNAM INVESTMENTS putnam.com following the end of the 2001 recession. The federal funds rate was reduced to less than 2% and the economic growth rate accelerated from 1.6% in the last quarter of 2001 to 7.5% in the third quarter of Altogether, over five years, leveraged-company stocks doubled the return of the S&P 500 (Figure 2). High-yield bonds and bank loans also provided strong returns in the same period. Relative performance can vary in other time frames, but as the economy gradually began to recover from the 2008 financial crisis, leveraged-company stocks, high-yield bonds, and bank loans once again showed their ability to perform well relative to the broad equity market (Figure 3). Debt securities of leveraged companies offer total return and lower volatility potential The debt securities of leveraged companies include high-yield bonds and bank loan securities, investments that can provide attractive total return through a combination of current income and capital appreciation. In addition, the debt of leveraged companies tends to be less volatile than the equity securities, as measured by standard deviation over multi-year periods. With these characteristics, debt securities can help to diversify a portfolio of leveraged-company equities. Adding high-yield bonds and bank loans to a portfolio of leveraged-company equities can significantly reduce its volatility (Figure 4). Figure 2. Leveraged-company stocks, bonds, and bank loans were competitive with stocks during the last economic recovery, 12/31/01 12/31/ % 10.61% 6.19% 5.75% Leveraged-company stocks Stocks High-yield bonds Bank loans Figure 3. Leveraged-company security indexes have remained competitive with stocks in the current recovery, 6/30/09 12/31/14* 17.08% 18.25% 12.61% 7.71% Leveraged-company stocks Stocks High-yield bonds Bank loans 1Expansion start date as determined by the National Bureau of Economic Research. Figures 2 and 3 are for informational purposes only and do not reflect the performance of any Putnam investment product, which will differ. Leveraged-company stocks are measured by the Credit Suisse Leveraged Equity Index, which includes companies that issue high-yield corporate bonds included in the Credit Suisse High Yield Bond Index; stocks are measured by the S&P 500 Index, a broad measure of stock market performance; high-yield bonds are measured by the JPMorgan Developed High Yield Index, which represents high-yield fixed-income securities issued in developed countries; and bank loans are measured by the S&P/LSTA Leveraged Loan Index, which represents bank loans issued to leveraged companies. Indexes are unmanaged and do not reflect any fees or expenses, and you cannot invest directly in an index. Past performance is not indicative of future results, and results may differ over other performance periods. Putnam Capital Spectrum Fund and Putnam Equity Spectrum Fund have no long-term performance history. 3

4 FEBRUARY 2015 Opportunity in leveraged companies Figure 4. Diversification across equity and debt securities reduced volatility in 3-year index performance, 12/31/11 12/31/ % CS Leveraged Equity Index Source: Putnam Investments. 7.64% Blended Index This chart is for informational purposes only. It does not reflect the performance of any Putnam fund, which will differ. Leveraged-company stocks are represented by the Credit Suisse Leveraged Equity Index. The hypothetical portfolio is composed of a 50% allocation to the Credit Suisse Leveraged Equity Index, a 30% allocation to the JPMorgan Developed High Yield Index, and a 20% allocation to the Barclays U.S. High Yield Loan Index, which is an unmanaged index that provides broad and comprehensive total return metrics of the universe of U.S. dollar denominated syndicated term loans. Indexes are unmanaged and do not reflect any fees or expenses, and you cannot invest directly in an index. Past performance is not indicative of future results, and results may differ over other performance periods. Standard deviation measures how widely a set of values varies from the mean. It is a historical measure of the variability of return earned by an investment portfolio. Putnam Capital Spectrum Fund and Putnam Equity Spectrum Fund have no long-term performance history. Analyzing leveraged companies Selecting attractive securities of leveraged companies requires a different focus than general equity investing. Traditional equity investing styles growth and value investing focus on finding companies with aboveaverage earnings growth or below-average valuations. Selecting leveraged companies requires thorough understanding of corporate finance, accounting, and the intricacies of the corporate capital structure. The capital structure is a hierarchy of claims on a company, and each level has different features and a different priority. As the capital structure diagram shows, the hierarchy places bank loans at the top, followed by bonds (also called debentures or fixed-income securities), convertibles and preferred equity, common equity, and rights and warrants. An x-ray of the capital structure The capital structure is represented as an inverted triangle because, in most leveraged companies, bank loans tend to compose the largest slice of the corporate capital structure, in terms of value, followed by bonds and equities (Figure 5). This reflects the relatively high debt burdens of leveraged companies. Bank loans are at the top of the structure because, in the event of a corporate reorganization, they have the first claims on cash flows. In addition, bank loans are considered secured because they are typically backed by collateral, such as a company s buildings or equipment, or its receivables from customers. Bonds have second priority after loans. Since most bonds are not secured by collateral, they generally pay higher yields to compensate investors for risk. These bonds are typically part of the high-yield asset class. At the level of equities, preferred shares generally earn a dividend, but lack voting rights, while common equity shares have voting rights, but might not earn a dividend. In the event of a company reorganization or liquidation, preferred shareholders are positioned ahead of common equity shareholders for distributions. Convertibles are technically bonds, except that they can be exchanged for specified amounts of common stock when the stock reaches a predetermined price. This feature influences their performance. Warrants are options issued by a company that permit the owner to buy shares of common stock at a specified price. Rights are new shares issued to owners of existing shares in proportion to their current holdings, which raises new capital for the company without diluting the ownership of current shareholders. Why be a common equity shareholder and rank last in the hierarchy? The reason is that common equity shareholders own what is left after investors at all other levels of the capital structure receive what is due them. For all of the higher levels, the claims are more or less fixed. In short, when the company outperforms, all of the extra benefit flows to the common equity shareholders. PUTNAM INVESTMENTS putnam.com 4

5 PUTNAM INVESTMENTS putnam.com Figure 5. Understanding corporate capital structure Higher protection Yes Bank loans Low High-yield debt High Convertibles and preferred equity Low Common equity Low (if any) Rights and warrants Less protection Collateral Yield potential This illustration does not represent the structure of the Spectrum funds or their protection against an issuer s default or bankruptcy. Also, individual companies may have different capital structures. The illustration instead shows that securities at different levels of a capital structure vary in the actual and perceived protection for investors in the case of bankruptcy, and that these protections diminish at each successively lower level. Investors should consider which type of security best fits their specific risk-and-return goals. A skilled and experienced investment manager may be able to find a variety of attractive opportunities hidden in a leveraged company s capital structure, from high-yielding income securities to undervalued equities and bonds. Putnam Capital Spectrum and Putnam Equity Spectrum These two strategies can benefit from leveraged companies and the recovery of the U.S. economy in coming years. Putnam has two portfolios managed by David Glancy: Putnam Capital Spectrum and Putnam Equity Spectrum. They offer alternatives to investors trying to navigate through today s volatile market conditions. In the context of the ongoing U.S. economic recovery from the financial crisis of 2008, we believe the range of attractive investment opportunities in leveraged companies has expanded. These portfolios can benefit as individual U.S. businesses and the broader economy continue to strengthen. The Putnam Capital Spectrum strategy seeks total return. The manager pursues the total return opportunities of leveraged companies by investing in equities, fixed-income securities, and bank loans that can offer a combination of capital appreciation and current income. Diversification across these different types of securities can help reduce volatility compared with a strategy that invests only in equities. Debt securities have a risk profile that is different from equities because they have a par value at maturity. As debt securities approach the maturity date, their prices pull toward the par value. Equities, on the other hand, have no par value and theoretically have the potential to appreciate to ever higher levels, depending on company performance. 5

6 FEBRUARY 2015 Opportunity in leveraged companies The Putnam Equity Spectrum strategy seeks capital appreciation. The manager pursues the growth potential of leveraged companies by investing in equity securities. By focusing on equities, this strategy can harness the greatest upside potential of leveraged companies. When these companies are in great business distress, all of their securities can become deeply discounted. However, equities can fall further in price. Common equity shares can fall by a greater magnitude because they are the lowest in the capital structure, and typically do not provide current income as debt securities do. Equities also have the potential to appreciate in value to a greater extent. Although the strategies invest primarily in companies that are leveraged, they do not use leverage themselves as a primary investment strategy. The strategies invest with a rigorous fundamental process The investment process is based on thorough fundamental research into the securities of leveraged companies, focused on identifying securities with the most attractive total return potential relative to risk. The investment universe consists of companies with high debt levels relative to their earnings before interest payments, taxes, and depreciation (also known as EBITD) are taken into account. In analyzing companies, portfolio manager David Glancy has access to Putnam s complete range of investment capabilities. He consults with two research groups in particular: Putnam s High Yield Credit group and Putnam s Global Equity Research team. The first research step is to analyze each company as a business and understand its sources of cash flow, and the risks to it. The second is to analyze the company s capital structure and see what opportunities and risks it poses. The opportunities and risks within the capital structure result from the company s ability to generate sufficient cash flow to cover the liabilities at each level of the capital structure. The chief risks are the possibilities of bankruptcy, reorganization, or liquidation. The different scenarios for the company can have a varying impact on each type of security. For example, bank loans might be most attractive if a bankruptcy is probable. However, securities at any level of the capital structure might be mispriced by different amounts, because the market for leveraged-company securities tends to be inefficient. After analyzing the opportunities and scenarios for each company, the portfolio manager revisits his forecasts to determine his level of confidence and conviction in each one. After determining the securities he finds most attractive, Mr. Glancy carefully constructs each portfolio by balancing the risks of different securities. He has latitude to establish large weightings in individual securities, with the goal of providing the best overall trade-off between potential return and risk. Short-selling capability expands opportunities Unlike most Putnam offerings, these strategies have the capability to short-sell securities, which may allow them to profit from securities that the portfolio manager considers to be overvalued rather than undervalued. In the inefficient area of leveraged companies, many securities tend to be mispriced, but this tendency can result in overvaluations as well as undervaluations. When Mr. Glancy identifies securities he considers overvalued, he can use the tool of short-selling to seek a positive return (see sidebar on the next page for an example). The securities that are borrowed to effect short sales will be collateralized by cash instruments. Of course, short-selling has risks. If a short-sold security increases in value, the short position loses value, offsetting the cash held as collateral and perhaps additional assets. The transaction could result in a net loss. To manage the risks of short-selling, Putnam currently expects to use only cash for collateral. This measure limits the impact to the portfolios if the short positions do not succeed. The advantage of the flexibility to use short-selling is that it allows Mr. Glancy to exercise more of his research, insights, and skills. In the process of analyzing companies as candidates for the portfolio, he may find securities that are priced above their worth. Short-selling allows a strategy to seek to profit from these opportunities, rather than exclude them from the portfolio. Short-selling can make the strategies more competitive as long-term investments because it gives the portfolios an additional tool to use during bear markets. When the prevailing market trend is negative, it provides a bountiful PUTNAM INVESTMENTS putnam.com 6

7 PUTNAM INVESTMENTS putnam.com setting for short-selling strategies. In these periods, short-selling securities can give the strategies a source of positive results to offset the impact of a bear market. In periods when stock prices generally increase, the opposite may be true. Define the universe of leveraged opportunities Identify companies with high debt relative to earnings (Debt/EBITD) Target companies recently privatized in leveraged transactions Analyze companies to understand how the business generates earnings Analyze capital structure Determine level of confidence Company selection Determine scenarios for future cash flows Assess risks to future earnings Forecast scenarios Risk of bankruptcy? Possibility of capital structure reorganization? Potential for income or capital appreciation? How short-selling works: A hypothetical example 1. The manager identifies security Z, which he believes is priced above its worth based on analysis of the company and its capital structure. Security Z Current market price is $10 Fundamental worth, as determined by fund manager, is $5 2. The manager then enters an agreement with institution Y, which owns Z shares, to borrow 100 shares for the portfolio. The manager sells the Z shares in the market and applies the proceeds ($10 x 100 = $1,000) toward the collateral required for the loan. 3. Fund impact Receives $1,000 in cash Owes 100 shares of Z to institution Y Capital Spectrum Equity Spectrum Security selection Compare total return potential of loans, bonds, convertibles, and stocks Determine most attractive securities for long positions Decide whether to short-sell any securities Determine equities with greatest total return potential Decide whether to short-sell any securities 4. Outcome If the manager s forecast is accurate, the price of Z falls to $5 per share. The borrowed securities are now worth $500. The manager enters the market and purchases 100 shares of Z at $5 per share, spending $500. The manager returns 100 shares of Z to institution Y. The portfolio earns $500 from the initial $1,000 transaction, not including interest and transaction costs to purchase Z shares in the market. Portfolio construction Determine optimal weightings of long and short positions Make large concentrations in most attractive opportunities 5. Risk If the manager s forecast is inaccurate and the price of Z rises above $10, the manager must use available cash, and perhaps sell other portfolio holdings, to repurchase Z shares and return them to Y. Balance short sales with cash positions to minimize the chance of exceeding 100% gross market exposure 7

8 FEBRUARY 2015 Opportunity in leveraged companies Active strategies for diversifying a portfolio The Putnam Capital Spectrum and Putnam Equity Spectrum strategies offer advantages for investing in below-investment-grade securities that most individual investors lack. They are professionally managed and diversified with holdings in many different securities, which reduces the risk of investing in the securities of only one company. The strategies can benefit from a recovery in the performance of leveraged companies as the economy emerges from recession. They can complement a core portfolio holding such as an absolute return or asset allocation strategy, or traditional stock and bond portfolios. Consider these risks before you invest: Investments in small and/or midsize companies increase the risk of greater price fluctuations. Growth stocks may be more susceptible to earnings disappointments, and value stocks may fail to rebound. Our focus on leveraged companies and the funds non-diversified status can increase the funds vulnerability to these factors. The use of short selling may increase these risks. Stock prices may fall or fail to rise over time for several reasons, including general financial market conditions and factors related to a specific issuer company or industry. You can lose money by investing in the funds. For Capital Spectrum, these risks also apply: Lowerrated bonds may offer higher yields in return for more risk. Growth stocks may be more susceptible to earnings disappointments, and value stocks may fail to rebound. Bond investments are subject to interest-rate risk (the risk of bond prices falling if interest rates rise) and credit risk (the risk of an issuer defaulting on interest or principal payments). Interest-rate risk is greater for longer-term bonds, and credit risk is greater for below-investment-grade bonds. Unlike bonds, funds that invest in bonds have fees and expenses. Our use of short selling may increase these risks. Mortgage-backed securities are subject to prepayment risk and the risk that they may increase in value less when interest rates decline and decline in value more when interest rates rise. Stock and bond prices may fall or fail to rise over time for several reasons, including general financial market conditions and factors related to a specific issuer or industry. The information provided relates to Putnam Investments and its affiliates, which include Putnam Advisory Company, LLC, and Putnam Investments Limited. Diversification does not guarantee a profit or ensure against loss. It is possible to lose money in a diversified portfolio. Strategies that use leverage extensively to gain exposure to various markets may not be suitable for all investors. Any use of leverage exposes the strategy to risk of loss. In some cases, the risk may be substantial. Request a prospectus, or a summary prospectus if available, from your financial representative or by calling The prospectus includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. Putnam Retail Management One Post Office Square Boston, MA putnam.com II /15