Today, we revisit one of the most interesting projects we’ve worked on since starting Valens: treating energy market investing like venture capitalists.
Learning from some venture capital legends, and adding distressed debt investing knowledge and UAFRS, we were able to identify a portfolio strategy that beat the market by over 7x in just two months.
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There are a number of sources listing different failure rates for venture capital investments. Something from 50% to 90% of investments fail depending on what you read.
In the book The Business of Venture Capital, by Mahendra Ramsinghani, he notes a very specific number:
“62.4 percent of VC investments were completely lost…”
So how is it that venture capital (VC) firms like Andreessen Horowitz are able to beat the public markets so regularly? Well it’s mostly due to the second part of that quote:
“…3.1 percent of the investments accounted for 53 percent of the profits…”
A general rule of thumb we’ve seen is as follows:
90% of investments will lose money, 9% will make you your money back, and 1% will be how you actually make money.
The best venture capitalists have found ways to maximize the return on that 1% (or 3.1% specifically, if we take Mr. Ramsinghani’s numbers).
Those are the Googles, Facebooks, and Ubers of the world, that make so much money for their investors, that losing money on 90% of the other investments isn’t an issue.
While VC is something of an extreme when thinking about portfolio construction, it isn’t unique in this approach. In fact, in the right conditions, this portfolio building approach can be as good in distressed credit as it is in venture capital.
On the other side of the equation, you have a firm like Canyon Capital that focuses on deep value in more traditional markets.
They are looking at distressed and defaulted debt, and aren’t looking for every investment to be a winner. They are looking for those investments that do win to return an outsized amount relative to the risk they took on.
When Canyon is investing in companies like utility giant PG&E while it’s preparing for bankruptcy, or considering investments in Sears as it’s going through Chapter 11, it’s easier to win by hitting a couple of home runs and striking out a few times. They don’t try to slap a bunch of singles.
That is why, when we got the opportunity to do similar research in late 2014, we jumped at the chance.
In November and December 2014, the entire energy market was in the middle of a panic. There were almost 150 bonds in the sector trading with yields over 10% at the time.
Much like Canyon, our clients saw an opportunity to make money. Even if several of the names lost money, or even went to zero, not every company was going to go bankrupt.
We used Uniform Accounting, and our proprietary Intrinsic CDS (“iCDS”) system to identify 23 names we thought would end up “money good”.
We recommended that our investors think like a VC in this situation—don’t try to pick which of those 23 will win, just buy the bonds of each, and take a small sliver of the equity too.
There were of course going to be names that lost some money. After all, at this point, oil prices had halved, and balance sheets were crumbling across the sector.
But if you held the whole portfolio, you were likely to see strong returns.
When all was said and done, in just two months, the bonds returned nearly 10%, and the stocks of those companies averaged over 22% returns.
The stock basket tripled the energy sector ETF, and was up over 7x the S&P 500 in the same timeframe. This included several names that were down, some by double digits. But this was outweighed though by the names that were up 50% or even over 100%.
It’s not always intuitive to think of credit markets, especially distressed credit, like the huge upside VC would. Our investors were able to think like VCs, and used that to make money in the energy market of all places.
While we don’t often come across opportunities like this, when we do, they are amongst the most compelling ideas we present to clients.
One of the home runs we hit at the time was a company called McDermott (MDR). The company’s bonds were priced below $65 when we originally highlighted the portfolio, and the bonds rapidly rose towards par, or $100.
Two months ago, the company forced itself into bankruptcy, but that was six years after the company was priced for an imminent collapse back in 2014. Below is a tearsheet summarizing McDermott’s fundamentals.
SUMMARY and McDermott International, Inc. Tearsheet
As the Uniform Accounting tearsheet for McDermott International, Inc. (MDR) highlights, the company’s Uniform P/E trades at 11x, which is well below both global average valuation levels and previous period valuations.
Low P/Es require low, and even negative, EPS growth to sustain them. In the case of McDermott International, the company has recently seen its Uniform EPS decline, which may be a signal that below-average valuations are justified.
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, McDermott International’s Wall Street analyst-driven EPS growth forecast flipped from positive to negative.
Based on current stock market valuations, we can back into the required earnings growth rate that would justify $1 per share. These are often referred to as market embedded expectations.
In order to meet the current market valuation levels for McDermott International, the company would have to have Uniform earnings shrink by 6% each year over the next three years.
Despite a weak year this year, Wall Street analysts’ expectations for McDermott International’s earnings growth are far below what the current stock market valuation requires.
In addition to McDermott International’s valuations being low, its Uniform P/E is significantly higher than peer averages, while its Uniform EPS growth is fairly below peer averages.
Meanwhile, the company’s earnings power is 3x higher than corporate averages, signaling very low risk to its dividend or operations.
To summarize, McDermott International, Inc. is a fairly high-profitability company with significantly low earnings growth potential and very bearish embedded expectations.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research