Blain's Morning Porridge - September 22nd 2017 - The Malone World View and How to catch rabies i

Blain’s Morning Porridge – September 21st 2017

“High on a cliff in gorgeous clothes, a madman danced on the balls of his toes..”

For the avoidance of doubt – the Morning Porridge is unrestricted market commentary, it is not investment advice…

It’s a bright Canary yellow morning here on Misery Wharf. I don’t know if that is a good or bad sign, but Steve thinks, on balance, its “bad”.. so we’ll go with that.. (Photo attached – can we get the windows washed?) It’s also the autumnal equinox, so I got up very early this morning, got the binoculars out and was treated to superb views of Orion – all of which means Winter is Coming..

Meanwhile, my skull is still ringing and my grey matter reeling from analysis concussion after spending yesterday afternoon with my Macro Economist, the mercurial Martin Malone. He took me through his exhaustive 100 page analysis: “Complete Macro Alignment” – an in-depth deep dive into 65 economies, central banks, policy and politics, mean reversion, and expected returns over the next 5-years. It was an absolute eye-opener.

Worse than that… I greatly fear he might just be right…

Martin’s conclusions are fascinating – unlike the bears who say we should be increasing “safe asset” bond allocations, scaling back risk assets like stocks and real assets like property, and panicking about bubbles, he says “turn that on its head” and buy “perceived” risk assets.

Now, those of you who have met or read Martin may harbour suspicions he’s utterly and completely hat-stand - and don’t forget he was a leading player on the Irish Olympic “talk” team. I admit there are times when I think his predictions look not just a couple of sandwiches but a whole rug short of a picnic, and I’m struck by his ability to ignore the “downright bleeding obvious” political noise so often disconcerting markets. Yet, his macro pronouncements are often spot on!

He ignores the noise, and focuses on the facts and numbers..

He’s got three core pillars to his expectations – we’ve got bullish fiscal and monetary policy, bullish politics, and resurgent bullish public sector confidence. Put these together with his analysis of 150 years of returns, a deep-dive into the way the output gap since the crisis has now turned positive across many economies, what central banks are doing (rather than just saying) and the risk/return equation between asset classes, and he turns around conventional investment visions. He’s spotted whole areas where current trends point to low yield/high risk returns on supposedly safe assets, and high yield/low risk rewards on the parts of the markets others consider poor.

His conclusions are simple and very revealing.

So… here’s the deal:

What can it hurt to at least listen to him? I’ll get Martin to come in and present the broad bones of his Macro Alignment thesis. If you like what you hear, you can sign up for his macro analysis and get the full presentation plus all his future thoughts. Martin’s Macro will cost from next year, but for this year you can pay us in trades – heh, heh, heh, - while its still legal before MiFID II turns market logic on its head.

I guarantee 60 mins with Martin will not be wasted time. It might cause permanent damage to your ear drums, but you’ll make so much money you’ll be able to buy new bionic ones.

If you’re interested, give me a shout or email. If enough folk are interested, I might arrange a Breakfast with Martin.. let me know!

Meanwhile, I’m sure everyone has been following the Toy R Us meltdown in the bond market. Alongside chapter 11 bankruptcy, its bonds have crashed from 96 to 18% through the month. Have we seen this before? Of course you have. Happens all the time. But, Blain’s Market Mantra No 3 reminds us: “Markets have no Memory. Buyers have even less.”

There are a number of things that worry me.

First is the market doesn’t seem to think Toy R Us is symptomatic of wider problems across the whole hi-yield and LBO sector. According to some I’ve spoken to, Toys R Us is one of few and even the “only” company caught in a debt trap – oh no it isn’t! Profit of about $500mm per annum covering debt service costs of, say, about $500 per annum. FFS! As the FT comments: the capital structure is “extremely complicated” leading to doubts on what is and isn’t senior or subordinated to what. It’s what we call messy.

Second, high yield spreads continue to tighten against bonds. Why? The risks are very very different across the credit spectrum, yet simplistic credit analysis treats them the same. Mistake to chase yield without understanding the risks. And go read all the stuff from 2007 about LBOs and how diversified risk is not reduced risk.

Third, there was a great article in the FT on Wednesday about Stada – the German drugmaker. It’s subject to an aggressive LBO and issuing substantial amounts of debt (bonds and loans) to fund it, allowing the PE buyers to strip out the cash. However, “buried deep in the 766 page offering memo”, says the FT, is a carve out of the obscure “restricted payments” clause allowing the private equity buyers to raise even more guaranteed debt to pay them dividends – a clear case of “the erosion of European Covenant Protections”.

It feels like a wake up and smell the coffee for the junk market… but I’ve been saying that for years… So I wont say it again…

It looks to me that complacent investors have been misreading the signs – foolishly thinking low rates meant highly levered private equity targets were somehow safe from debt crisis? In fact, debt remains front and centre the problem: as newspapers have noted; “while Toy R Us should have been spending its management resources maintaining relevancy versus Amazon and EBay, it was struggling with a debt mountain.” Doh.

What’s very obvious is holders ignored the first rule of investing in Leveraged Buy Outs: Don’t. Unless the goals of equity holders and debt are very clearly aligned – don’t go near them. Alignment of interest twixt equity and debt is critical and misalignment seems the basis of many takeovers…

Its 12 years since KKR, Bain and Vornado bought out Toy R Us. Guess who is also involved in the Stada buyout? If you guesses Bain, give yourself a big pat on the back.

Anything is possible when markets are so distorted that the hunt for yield overcomes common sense and folk are willing to ignore the need for protection against unrewarded risk. Common sense is a very uncommon thing..

Back in the real world.. I suppose we can spend the weekend fretting about Norte Korea. I tried to read stuff on the German election, hoping to come out with a killer bon-mot about Merkel, but it was just too dull and boring to bother.

I’m off to Edinburgh later this evening… Have a great weekend.

Bill Blain