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The hunt for value in corporate bonds

Daniel_Dolan-Roger_McEniryDaniel D. Dolan, Jr., Managing Member & Roger S. McEniry, Managing Member, Dolan McEniry Capital Management (Partner of iM Global Partner since 2016)

2021 could be another challenging year for fixed income investment managers. Here, our experts explain how their strategy has survived many difficult periods with no corporate defaults in 23 years.

Many investors base their investment philosophies in macro factors—forecasting interest rates and currencies or calling the rotations among sectors in the corporate bond market—and some navigate these high-level global trends quite well. We’re not a macro-driven firm, in that we don’t base our investment decisions on the future of interest rates, or trends in corporate credit spreads. It’s not that we ignore the big picture—we monitor economic and monetary developments closely—but we certainly have no influence over any of them, and more importantly, we’ve not found a way to build them constructively into our investment process.

Instead, we emphasize credit quality, the cash flow of individual issuers and the prices we must pay for the most attractive bonds. Whether rates are high and credit spreads are wide, or low and tight, our job of picking the most attractive bonds remains the same. We’ve held this philosophy through the many and varied market regimes we’ve encountered since founding the firm in 1997.

Finding our own way
Aside from macro considerations, another prominent financial variable that doesn’t determine our investment process is the credit assessments on issuers and bonds published by the rating agencies. We don’t ignore ratings, but rather give them very little weight in our decisions. Nor do we rely on the gigabytes of research produced by brokerage firms’ research departments. We are skilled analysts and believe that our in-depth study affords us a far better knowledge of individual credit.

To be fair, in most instances, the agencies are correct in their ratings. But in a sufficient number of cases they’re too optimistic or negative. This makes an already imperfect market even more so, providing independent-thinking investors with opportunities.

We also don’t interact much with the managers of the corporations that issue our bonds. On earnings conference calls and marathon sessions with investors, they can be quite persuasive about the strength of the latest quarter. We generally find them to be too optimistic and filter out that information in favor of our own analytics.

Cash flow is the source of all value
We follow a two-stage investment process. The first looks at trends in companies’ cash flow.

Cash flow funds existing operations, expansion of businesses, dividends to owners and, crucially for bondholders, interest and principal payments on past borrowing. In our portfolio, we seek a generous margin of safety between a company’s cash flow, and the demands of the business.

Managements’ cash flow allocation decisions are critical. Do they invest in capital expenditures for a reasonable return? Are they prudent with working capital, or do they use it to cover the tracks of tactical errors?

With an eye toward fully understanding our companies’ cash flow profiles, there are certain sectors that we have chosen to avoid or minimize. We look for businesses that we can readily comprehend, and report an understandable gross profit and operating margin, and we naturally favor those with high returns on investment.

These parameters tend to rule out financial companies, for their complex financial reporting, but they include manufacturing, retail, consumer, and low-technology businesses, given that they possess strong brands and high market shares. Stellar revenue growth is not a prerequisite, as long as the operating cash flows afford us a margin of safety that can be cut in half, while still servicing and paying off debt.

Avoiding some of these areas was beneficial in 2020, but several areas we invest in were also impacted as the retail sector was severely affected as consumers adjusted their habits amid stay-at-home orders and business shutdowns in many states and cities. With our holdings in industries like retail, travel, and leisure, we were very focused during the COVID-19 crisis on balance sheet strength. How much cash does the company have? How large are their committed lines of credit? In essence, do they have the staying power to manage through an extended period of reduced earnings and cash flow?

The second stage of our investment process is the selection of securities for the portfolios. From companies’ long-term financial histories, we develop a ratio of financial safety that compares an adjusted cash flow measure to their interest obligations. These ratios are ranked, and compared to yields on individual bonds, to develop a list of the most attractive securities on both measures.

We then look further into issuers and securities through a qualitative lens, searching for businesses we like and bonds of sufficient market liquidity. We also consider the fundamentals of the issuers and bonds we already own, looking for deterioration in businesses or other unanticipated events. From the flows of portfolio buys and sells that we initiate, and the maturing or calling of bonds, portfolio turnover is typically about 40 percent per year.

Strong results
Our principle of limiting the number of positions held allows us to deliver a concentrated portfolio of our best ideas to our clients.  We want to consistently outperform benchmarks and have found that 40 positions or so are sufficient to offer plenty of diversification.

Owning hundreds of additional securities in the name of diversification would necessarily make our portfolios resemble the indexes, which is at odds with providing a differentiated return. Moreover, spreading our internal research process too thin over a large number of securities, or having to rely heavily on third-party research as inputs to our decisions, would dilute our ability to make informed decisions.

We have developed our investment philosophy carefully and carried it out conservatively, with the goal of finding great value and never losing money. And in the 23-year history of the firm, our corporate bond portfolios have never suffered a default.

For discussion purposes only: The information and data contained in this document does not in any way constitute an offer or recommendation or advice to buy or sell financial instruments.

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