As published in the Financial Post on 23 June 2024.
Credit spreads serve as a premium offered to investors to offset the risks associated with bankruptcy. This quarter, high-yield credit spreads hit a decade-low of 3.05%. Narrower spreads reflect reduced demand for compensation against credit risk, indicating the market’s confidence in low credit risk ahead. However, this optimism leaves little room for margins of safety. Despite robust economic indicators and persistent inflation concerns, the broader market fails to adequately compensate for risks, offering limited opportunities for risk adjusted returns. The situation calls out for Benjamin Graham’s observation that, “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”
Current market sentiment suggests a belief among investors that interest rates may have reached their peak, yet there is growing indication that the Federal Reserve will prolong elevated rates to combat inflation, targeting a 2% level. Large-cap equity markets are hovering near historic highs, largely influenced by AI optimism, leading to inflated valuations and dwindling risk premiums, particularly in the large-cap US equities, (now rebranded “The Magnificent Five”), and in the high-yield indices. However, concerns are emerging across various fronts, potentially spilling over into broader markets. Political discontent in North America, Europe, and globally; soaring government debts; ongoing military conflicts (including those involving major powers) in Ukraine, Haiti, parts of Africa and the Middle East, and competing views on the societal impact of artificial intelligence.
Predicting market shifts is always challenging and, therefore, unreliable. Changes often occur swiftly, catching many off-guard with their magnitude and impact. While it seems that we are at a juncture where a market pullback may be imminent, small-to-mid size firms may excel regardless. Their attractive valuations, coupled with ongoing earnings growth, position them favorably, despite facing the highest capital scarcity in the market segment.
As Warren Buffett has said, “Size did us in…For a while, we had an abundance of candidates to evaluate. If I missed one — and I missed plenty — another always came along. Those days are long behind us.” Berkshire Hathaway is a US$905 billion enterprise. Moving the needle on performance would require buying a mammoth-sized company. The same competition for assets applies to private credit giants, such as Oaktree Capital, which, by necessity, cannot consider the secondary market composed of small-to-mid-size companies due to liquidity restraints.
On the other hand, size is a significant asset for smaller funds that are less dependent on credit cycles and have a much larger opportunity set of small-to-mid size capital structures. These could include unrated credits with compelling spreads that are often overlooked by the indices and by larger firms. Smaller companies with straightforward capital structures may present significant yield potential and catalysts for growth. For example, in the distressed sector, it is possible to identify opportunities with spreads surpassing 1000 basis points. Similarly, in stressed assets, there are spreads exceeding 600 basis points.
Today, sectors experiencing capital scarcity that have fallen out of favor with investors include healthcare, biotech, electric vehicles, and cannabis. Looking ahead, we believe the next five years hold immense potential for investing in stressed and distressed credits.
