Readers of this blog will already be aware that we like to keep an eye on credit markets to help inform our views on equity markets, business qualities and prospects. Credit markets often provide leading indicators to impending changes in equity markets.
The Wall Street Journal recently noted some deterioration in the credit quality of US companies. As illustrated below, default rates have started to tick up; S&P is downgrading the ratings of more companies than since the financial crisis; and interest coverage ratios have started to turn down.
Furthermore, we observe the chart below provided by Citi. It illustrates the recent acceleration in the ratio between debt and earnings (before interest, tax, depreciation and amortisation) in both Investment Grade and High Yield bond issuers. At face value, this chart suggests an acceleration in financial leverage across these issuers.
The above charts are concerning: if credit quality is deteriorating, then surely equity quality is too. After all, creditors have a claim on company assets that is more senior to the claim held by equity holders. Yet we would urge caution before rushing to sell all of your US equities.
It is worth being more selective in this analysis. For example, around one-third of the credit-rating downgrades relate to oil and gas companies following the collapse in the oil price last year. It is perhaps not surprising, therefore, to observe a net short exposure to the energy and materials sector to the tune of 13.7% (of net asset value) in the Montaka portfolio at the end of October.
On the other hand, consider the highly free cash flow generative technology businesses with clean balance sheets such as: Apple, Qualcomm and Playtech. These businesses carry effectively zero credit risk. It should not be surprising to see businesses such as these in Montaka’s long portfolio.
This is what we call “selective diversification” here at Montaka. We do not believe in diversifying for the sake of it. Why hold oil and gas businesses in the long portfolio at a time when balance sheets are stretched and oil prices are likely going to remain lower for longer? Instead, we believe in diversifying across the industries that are strong and improving in the long portfolio; and across those which are deteriorating in the short portfolio. We believe this approach to diversification will deliver superior outcomes for Montaka’s clients over the medium term.
Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.