Analysis

A mentor, one of the top hedge fund earners in the world, sees alpha in cross-capital credit and equity research… recognizing failures of GAAP

January 24, 2020

This investor taught me to open my eyes to the credit world… and its power when viewing the equity markets.

He has an uncanny understanding of how to unravel accounting distortions. That knowledge creates opportunities for both equity and credit markets. It has led to an incredibly impressive performance since he founded his hedge fund in 1990.

We look at how his cross-capital investing fund is built to generate such strong returns. Seeing through the accounting noise, identifying similar signals through Uniform Accounting (UAFRS).

The results are unsurprising. Using GAAP as-reported financial metrics, the investments in this fund’s portfolio look like someone is wading through distressed credits in confusion.

In reality, UAFRS-based financial metrics show how this cross-capital strategy is identifying diamonds in the rough to create significant value.

In addition to examining the portfolio, we’re including a deeper look into the fund’s largest current holding, providing you with the current Uniform Accounting Performance and Valuation Tearsheet for that company.

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In 1999, I found myself in Las Vegas. I was 29 years old, and I had been invited to speak at a conference in Las Vegas. It was the first high-yield debt summit, at the MGM casino.

As I was preparing my presentation, I saw Mitch Julis on stage as well. I knew him as one of the conference sponsors. I didn’t know how great an investor he was and would prove to be.

I asked Mitch why he had invited me to speak at the conference. After all, I thought I was an “equity guy.”

Mitch explained it in the following way,

“Identify the accounting issues you see at the business…

The credit investors will understand what that means for the credit.”

Even more than 20 years ago, I was already heavy into this subject of not trusting the as-reported numbers.

Mitch’s advice really opened my eyes to the credit markets.

What he was saying was that the accounting distortions that equity investors need to correct to accurately understand a stock… are many of the same issues creditors need to focus on, too.

Both groups are investing in the performance of the companies. The bonds or stocks they are investing in are just derivatives of the underlying cash flows of the business.

That advice was a big contributor to why our firm today is a “cross-capital” shop. It’s why we focus on analysis on both corporate credit and equities.

Uniform Accounting lets us better understand what a company’s equity is worth. We also focus on how Uniform Accounting can help us better understand what a company’s intrinsic credit risk is, and therefore when its credit could be mispriced.

Little did I know at the time, but the person giving me that advice was an investor that Bruce Greenwald, a key advisor to Jean-Marie Eveillard’s First Eagle and a professor at Columbia University that has been referred to as “a guru to Wall Street gurus,” considers as one of the best value investors.

He’s also earned more than $150 million in a single year more than once. He and his partner appear frequently on Forbes’ list of highest earning hedge fund managers.

Mitch Julis founded Canyon Capital in 1990 with his partner Josh Friedman. Canyon is a cross-capital investing firm. The firm spends a great deal of its time investing in distressed and high yield credits, and also in equities, as it seeks to invest across the capital structure, in both equity and credit markets.

Often, Canyon is attempting to use information on a company that its analysts identify in one of the two markets to find mispriced assets in the other market, and sometimes to arbitrage the two markets.

From my experience living in the land of Wall Street research, in most, if not all sell-side firms, equity analysts and credit analysts do not communicate.

Even getting them in the same room, let alone getting them to share notes on a company, or come to a consistent opinion about a company is near impossible.

However, that creates a compelling opportunity for investors who understand how the markets interact and the information that both markets pay attention to.

That is what Canyon focuses on. Canyon doesn’t just focus on seeing information across markets, but also seeing where both markets misunderstand a company’s performance because of accounting distortions.

As Julis highlighted to me, if you can identify the real accounting performance, credit (and equity) investors should know what to do.

He and Canyon’s analysts know they can’t trust as-reported accounting statements.

To show how much they do not trust as-reported accounting, we’ve conducted a portfolio audit of Canyon’s top equity holdings, based on their most recent 13-F, focusing on their non-financial company holdings.

We’re showing a summarized and abbreviated analysis of how we work with institutional investors to analyze their portfolios.

Unsurprisingly, for the most part, Canyon’s research appears to line up with Uniform Accounting.

Uniform Accounting metrics highlight the company’s equity investments are much higher quality, and have higher potential, than the market and as-reported metrics imply.

See for yourself below.

Using as-reported accounting, investors might think what Canyon wants investors to think… it’s buying distressed names with low odds of turning around. In reality, what Canyon is doing is seeing through the accounting noise and picking up names markets are completely misunderstanding, often because of accounting issues.

The average company in the portfolio displays an impressive average Uniform return on assets (ROA) at 16%. That’s well above corporate average returns currently and above what one would expect in an average distressed portfolio.

On an as-reported basis, many of these companies are poor performers with returns below 5%-6%, and the average as-reported ROA is only 2%-3%.

However, once we make Uniform Accounting (UAFRS) adjustments to accurately calculate earning power, we can see that the returns of the companies in Canyon’s portfolio are much more robust.

Once the distortions from as-reported accounting are removed, we can realize that Ceasars (CZR) doesn’t have a 3% ROA, it is actually at 12%. Caesars isn’t a low-return distressed company with credit woes. It is a company with robust cash flows that Canyon thinks is misunderstood, by both equity and credit investors.

Similarly, j2 Global’s (JCOM) ROA is really 77%, not 6%. While investors think j2 is in a dying business and has debt maturity headwalls, Canyon’s focus on better accounting and credit analytics recognize a high return business with cash flows to handle obligations.

RealPage (RP) is another great example of as-reported metrics mis-representing the company’s profitability.

RealPage doesn’t have a 3% ROA, it is actually at 34%. Canyon appears to be wading in a poor performing software firm that should have never taken on the debt they have. But Uniform Accounting lines up with Canyon’s decision making, RealPage is really a high return business with ability to service its credit obligations.

The list goes on from there, for names ranging from Arconic (ARNC) and Microchip (MCHP), to Jazz Pharmaceuticals (JAZZ), Ligand (LGND), and Avaya (AVYA).

If Canyon’s investment strategy was powered by as-reported metrics, it would never pick most of these companies, because they look like bad companies, and poor investments.

But to find companies that can deliver alpha beyond the market, just finding companies where as-reported metrics mis-represent a company’s real profitability is insufficient.

To really generate alpha, any investor also needs to identify where the market is significantly undervaluing the company’s potential.

Canyon is also investing in companies that the market has low expectations for, low expectations the companies can exceed.

This chart shows three interesting data points:

– The first datapoint is what uniform earnings growth is forecast to be over the next two years, when we take consensus Wall Street estimates and we convert them to the Uniform Accounting framework. This represents the uniform earnings growth the company is likely to have, the next two years

– The second datapoint is what the market thinks uniform earnings growth is going to be for the next two years. Here, we are showing how much the company needs to grow uniform earnings by in the next 2 years to justify the current stock price of the company. If you’ve been reading our daily and our reports for a while, you’ll be familiar with the term embedded expectations. This is the market’s embedded expectations for uniform earnings growth

– The final datapoint is the spread between how much the company’s uniform earnings could grow if the Uniform Accounting adjusted earnings estimates are right, and what the market expects uniform earnings growth to be

The average company in the US is forecast to have 5% annual Uniform Accounting earnings growth over the next 2 years. Canyon’s holdings are forecast by analysts to outpace that, growing at 9% a year the next 2 years, on average.

Even better, on average, the market is pricing these companies to actually shrink earnings by 16% a year. While these companies are growing faster than the market, they are intrinsically undervalued, as the market is mispricing their growth by 25% on average.

Even when looking at median levels, the market is mispricing these companies earnings growth by 12%.

These are the kinds of companies that are likely to see their stocks rally when the market realizes how wrong it is. This is especially true when the market is pricing some of them for massive declines in profitability and distressed credit situations. Without Uniform numbers, the GAAP numbers would leave everyone confused.

One example of a company in the Canyon portfolio that has growth potential that the market is mispricing is Jazz Pharmaceuticals (JAZZ). Jazz’ analyst forecasts have 9% Uniform earnings growth built in, but the market is pricing the company to have earnings shrink by 13% earnings each year for the next two years.

Another company with similar dislocations is Eldorado Resorts (ERI). This might look like a company Canyon is misunderstanding initially, with high market expectations.

Expectations may look high with market expectations for a 23% growth in earnings. However, the company is actually forecast for Uniform EPS to grow by 48% a year. While expectations are high, if it can deliver higher growth, there’s more upside.

Yet another is the fund’s largest holding, Akorn (AKRX), is priced for a 10% decline in uniform earnings, when they are forecast to grow by earnings by 50% a year.

That being said, sometimes investors miss what Uniform Accounting is picking up, or in Canyon’s case, the fund might be betting on specific events for the company that make earnings forecasts less relevant.

MGM Resorts (MGM) is forecast to see Uniform earnings shrink by 3% a year going forward, however the market is pricing the company for 7% annual earnings growth.

This doesn’t look like an intrinsically undervalued company. If anything, the market looks significantly too bullish.

But for the most part, Canyon’s quantitative portfolio looks like a high quality, undervalued set of stocks with businesses displaying strong earning power. It wouldn’t be clear under GAAP, but unsurprisingly Uniform Accounting and a system built to deliver alpha see the same signals.

Caesars Entertainment Tearsheet

As Canyon’s largest individual stock holding, we’re highlighting Caesar Entertainment’s tearsheet today.

As our Uniform Accounting tearsheet for Caesar Entertainment (CZR) highlights, Caesar Entertainment’s Uniform P/E trades at 54x, well above corporate average valuation levels and its own history.

High P/Es require high EPS growth to sustain them. In the case of CZR, the company has recently shown a -76% Uniform EPS growth.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Caesar Entertainment’s Wall Street analyst-driven forecast is for earnings to flip negative in 2019, and then to recover by roughly half in the succeeding year, although still remaining negative.

Based on current stock market valuations, we can back into the required earnings growth rate that would justify $12 per share. These are often referred to as market embedded expectations. In order to meet the current market valuation levels of Caesar Entertainment, the company would have to have Uniform earnings shrink by 5% each year over the next three years.

What Wall Street analysts expect for Caesar Entertainment’s earnings decline is much worse than what the current stock market valuation requires.

To conclude, Caesar Entertainment’s Uniform earnings growth is below peer averages in 2020. Also, the company is trading at well above average peer valuations.

The company has average earnings power, based on its Uniform return on assets calculation, compared with the 12% corporate averages in the US. Together, this signals moderate credit risk in the future.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research