At Peritus, we generate our own investment ideas, themes, and strategies and undertake our own credit work instead of relying on the Wall Street sell side propaganda. We believe that investing requires not only skill, but hard work and not cutting corners on the credit analysis process.
We begin with finding the securities to include in our portfolios. There is really no magic to the process except that our analysts and portfolio managers are voracious readers and are always on the hunt for opportunities. Here are just a few of the methods we use:
- Axe Sheets/Yield Screens: Every day investors like Peritus have access to a variety of dealers’ inventory of bonds, which are listed on what’s known as an “axe sheet.” As we scan through these and other yield screens put out by the investment banks and trading firms, often we find securities in the mix that we believe might be attractive.
- Insider Equity Purchases: Company insider buying of stock is something we have used effectively for years. Since equity is below us in the capital structure, this indicates a nice margin of safety for us as potential bond buyers.
- Industry Themes: Most value investors, including Peritus, are contrarians at heart. We believe in the philosophy of buying something when it is out of favor (i.e. straw hats in the winter). We are always on the lookout for industries or individual credits that are out of favor for what we believe to be wrong or temporary reasons.
Once we have a prospective credit, we begin the detailed and grinding process of credit analysis. What we have learned through our years in this business is that determining the true financial health of businesses is much more difficult than most people can grasp. We begin by looking at the three major financial statements produced by companies: the income statement, the balance sheet and the statement of cash flows. We conduct our credit and valuation analysis in reverse order to most conventional methods held by investors.
Financial Analysis
Traditionally, much time and attention is spent on the income statement yet we find it least valuable. The income statement can be and often is easily manipulated and not reflective of the true financial condition. A simple example will explain how. Company XYZ sells $100 million of widgets to the government. Their income statement shows a very nice profit of $25 million before taxes. Only one problem, the government doesn’t pay for their purchase. So while the income statement shows a lovely profit, the cash flow statement shows a massive cash suck and the balance sheet shows a huge account receivable line item. Our concept of “true free cash flow” incorporates both working capital and capital expenditures, which don’t show up on the income statement. This is why we “reverse engineer” the financial statement analysis. Simply put, if a business isn’t generating literal cash its financial health is questionable, so you better start by looking at the cash flow.
Through our fundamental and valuation analysis, we not only determine whether an investment should be made in a certain company, but also where in the capital structure (secured, senior, or subordinate) we believe the risk/return is most attractive. Additionally, our traders are engaged in each step of the security selection process, working intimately with analysts to effectively combine our expertise in market technicals with credit fundamentals. Because high yield is not an “exchange traded” asset class, the ability to find, negotiate, and acquire bonds is a critical component to execution. Once a credit is approved and purchased, we don’t stop there but continue to monitor the individual names and portfolio as a whole on a daily basis, quickly identifying any fundamental credit deterioration or downside exposure and overlaying our portfolio positioning with our market outlook.
Our end goal at Peritus is to hold a diversified basket of securities that generates what we view as a significant tangible yield to the investor and allows for some capital appreciation. What we don’t want is to be “di-worsified” by holding one of everything, which is not truly an active credit approach. Selectivity and discretion are key. Our preference and history is to hold approximately 40-70 securities in our portfolios, which we believe accomplishes our goals.
To pictorially summarize our process:
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