Eight investing words to live by

Capital earns higher returns where it is scarce

Some things in investing are complicated. The math can be cumbersome at points, and then there is the legal language in credit agreements. However, some powerful ideas in investing are very simple. And one of the simplest ideas is this: capital earns higher returns where it is scarce, rather than where it is plentiful.

To illustrate the concept, let us imagine a single rental property – say a house in a small town that nets income to the landlord of $1,000 per month. If a single buyer wished to purchase the house and paid $120,000, then the buyer’s return on his capital might be 10% p.a. But if two or three buyers were bidding for that house at auction, perhaps the house might fetch a much higher price. At $120,000, the house investment earns 10%; at $240,000, the investment yields only 5%.

The success that we have enjoyed over the past several years has been largely based on taking this simple idea and applying it to the bond and credit markets. What we have tried to do, fairly systematically, is position ourselves at spots without a lot of bidders, with an expectation that sooner or later the crowd will show up. The pandemic period has been particularly filled with fruitful examples of this approach. We were almost entirely alone in bidding for rate reset preferred shares below $10 in the spring of 2020 that now trade in fulsome liquidity above $20. We could almost name our price on senior oil and gas loans and bonds at the moment when oil briefly traded at a negative spot price, but now we see lots of prints on the tape at par or above.

But while the core idea is simple – invest where capital is scarce – putting it into practice, is a little more difficult. Capital scarcity doesn’t stay still. It moves around. One day the hot money crowd wants technology exposure and ignores food processing, and another day the situation is reversed. Another complication is that sometimes capital in a particular area is scarce for a good reason. Who wants to invest in, for example, Madoff Fund II?

In looking for opportunities to invest where capital is scarce, we do two things. First, we look for several clues that the crowd in a particular part of the market has thinned out. It doesn’t take Sherlock Holmes to notice these things, but where you see poor trailing returns, bad headlines, levels of investment that are below replacement levels, numerous brokerages “sell” recommendations…and, most of all, extraordinarily low prices vs history…well, you get a feeling that the crowd is thinning out.

The second thing we do is take a hard look at the quality of an enterprise. We are looking to see whether its unpopularity is warranted by a true collapse in value, or alternatively, if there are some transitory or cyclical factors which will one day disappear and reveal more attractive long-term economics. And where we find a decent enterprise looking for credit with few takers, that is an opportunity.

If it sounds simpler than it is, it is perhaps because it takes effort and focus to stay out of the way of the market’s trending mob. You won’t find us often in a crowded investment banker’s cocktail party, chomping smoked salmon canapes as we listen to a pitch about the “new” new thing, although we get plenty of invitations. We are busy in conference calls with the management teams of out-of-favour companies, listening to and critiquing their story and thinking about stepping into a void for their credit, which has recently gone “no bid.”

Geoff Castle is Portfolio Manager of the Pender Corporate Bond Fund at PenderFund Capital Management. Excerpted from the Pender Fixed Income – Manager’s Commentary – June 2021. Used with permission.

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