The Credit Risk Approach

It's been almost two years since my last post, a substantial amount of time in many ways. I've been busy, or perhaps I convinced myself that I've been busy. Since then, I've moved out of Singapore and into East Asia, learned for myself some traditional Mandarin, worked with international companies from around the world, touched the sands on both ends of the Pacific Ocean, hosted audiences numbering in the hundreds, chased my motorcycling dreams, solo-traveled to places that took my breath away, met amazing people, and ran a client portfolio that produced roughly 10 million greenbacks a year for my company.

I've been privileged to have this opportunity. Many holes in the cheese had to line up for a chance like this, but thoughts on humanly uncontrollable factors like luck and divine intervention aside, there have been many controllable aspects that were individually insufficient but absolutely necessary in leading to the existence of these past two years. Investing follows a similar logic; the various fundamental and technical analyses are the basic due diligence that are individually insufficient for guaranteed returns but also absolutely necessary in creating such. Investing otherwise would just be gambling with an elegant name.

How then do we do our due diligence? I used to lean toward an equity-based view in researching on companies and their businesses but I have to admit that my experience as a corporate banker has led me to consider a vastly different view on the matter; one that I believe complements the former instead of detracting away from it due to its stricter standards.

 Beverly Hills, California

The Credit Risk Approach

Corporate debt is widely known to be generally senior to shareholders' equity. This means that in the event that a company goes bankrupt, any available funds from asset liquidation go toward paying off debt holders before any shareholders even catch a glimpse of repayment. A company's total assets of $100 funded by $60 in debt and $40 in equity might only be worth $60 after liquidation, resulting in only the debt holders being repaid in full while the shareholders would be left with little but a story worth sharing over dinner and a few consolatory hugs.

 Shareholders (in blue) receive decreasing amounts when liquidated assets are insufficient to repay debt holders. 

Focusing on a company's credit risk helps us to avoid this potentially tear-jerking situation. Equity-based analysis tends to focus on the company's potential, growth trajectory, and valuation without sufficient attention to a company's ability to continue existing before it gets to its lofty multi-X returns. Conversely, the Credit Risk Approach provides a more tangible and sober view on the company's ability to continue being a going concern. Besides, if major lenders like banks and their army of industry specialists and credit analysts are not convinced, perhaps it's time we reassessed that persuasive equity story.

  Laomei Green Reef, Taiwan 

In today's world roiled by Covid-19 and a man in an orange tan, it becomes imperative to appreciate this. Dual-tipped stakes aimed at the hearts of companies come in the form of supply chain fractures and slouching demand. Manufacturing industries in Greater China are facing production capacities falling to unprecedented levels with a recent survey illuminating many firms averaging only 50% utilization running off the backs of shift workers under hastily made business continuity plans, virtually wiping out earnings at the gross profit level. Stay home notices, travel bans, and massive quarantines have already damaged exposed industries like aviation, tourism, hospitality, retail, and consumer services while other sectors are expected to face tailing off demand.

  Taipei 101, Taiwan

Investing in the current environment surely requires cherry picking of the toughest companies that can withstand a sudden deterioration while still poised to jump on opportunities in the form of industry consolidation or an improvement in the Covid-19 situation. Without doubt, some companies may be able to shore up resources during this period to increase longevity, but for how long? We need to be cognizant of the realities that, akin to financial markets, the existence of the Covid-19 virus and some companies could be a zero sum game. These are some of the factors to think about:

1. Core Liquidity: Sources and uses of cash depict the company's ability to meet its repayment obligations without overtly stressing its assets to generate cash flows. Key sources of cash include a company's operating cash flows and access to capital markets, while major uses of cash typically consist of capital expenditures, debt repayments, and dividends.

Questions to ask: Is the company able to generate enough cash to meet its payment obligations? Is it able to generate the same cash without breaching financial covenants and leading to an event of default, setting in motion a domino-effect leading to asset liquidation?

2. Available Assets: A company's assets can become its golden parachute in times of critical need. Unhindered land, office buildings, production facilities, and equipment generate value through disposal or mortgage, allowing a company to continue operations despite trying headwinds. The devil's in the details though; the quality of these assets directly affect the value that companies can squeeze out of them.

Questions to ask: What are the available assets in a company? How much value can they bring to the table when called on?

3. Management Team: An easily overlooked part of the spectrum is the executive committee steering the ship. It takes time to understand a senior team's overall personality and efficacy in facing various scenarios, though clarity in their current actions are sometimes immediately available - tactical alleviation of cash flow pressures through capital expenditure reduction, sound cost cutting measures without crippling operations, and swift refinancing of maturing debt are various examples.

Questions to ask: What has the management team been doing to ensure the company continues to be a going concern? Are these measures effective in meeting its desired outcome?

  Niseko, Japan

Apart from these three factors, many more can be considered and each company has its own specifics to be addressed. A solar energy provider might face daily operational and maintenance issues, while a semiconductor manufacturer might need to tackle a balancing act for capital expenditure related to its technology nodes and processes. It's up to us to identify the core difficulties each company will face and decide if it is doing the necessary and/or right things to survive and thrive in these market conditions brought about by a Force Majeure. If the former is true, it might be time to drop the pen and paper to execute that trade!

 Northern Coast Route, Taiwan

Until next time, happy investing!