“There can be few fields of human endeavour in which history counts for so little as in the world of finance.”
John Kenneth Galbraith
The Value Perspective’s folder of what we call ‘red-flag market indicators’ has started to bulge as, the best part of a decade into an equity bull market, investor confidence continues to mutate into complacency.
Grabbing our attention again is the growing popularity of so-called ‘covenant-lite loans’.
What are covenant-lite loans?
Covenant-lite loans are a type of financing that imposes less stringent terms on the borrower. For example if me or you wanted a personal loan from a bank they would have to check affordability, level of income and frequency of repayment to name a few. These checks and terms would not necessarily apply with covenant-lite loans.
Essentially they are a way of offering debt that would be impossible under a traditional loan agreement. Obviously this is also far riskier for the lender.
We first considered the subject in October 2013 in Fever pitch, when we noted issuance of these loans had already surged that year to an annual all-time high.
As the above chart shows, despite stiff opposition from 2014 and still-chunky showings by the subsequent two years, 2013 remained the high-water mark for covenant-lite loan issuance until it was comprehensively surpassed in 2017.
Even five years ago in Fever pitch, we were suggesting the amount of covenant-lite loans being issued represented one of the “risks building up across the market that people are as yet failing to acknowledge”.
Are covenent-lite loans worth the risk of issuing?
A loan with fewer covenants enables a lender to ask for a higher rate of interest but demand for covenant-lite loans is actually being driven by the borrowers. At certain points in the cycle, a company will ask a number of investment banks to pitch for the chance to lend it money and the banks will have to judge an appropriate balance between interest charged and covenants imposed.
What happens is the banks start degrading the terms and conditions in the loans in order to seal the deal.
Likened by some industry insiders to ‘death by a thousand cuts’, the pick-up in return from covenant-lite loans is rarely enough to compensate for the additional level of risk, which is why an apparent increase in issuance generally points to an inflating credit bubble.
As that wonderful JK Galbraith quote at the top of this piece implies – the market may be prone to regular bursts of amnesia, but here on The Value Perspective we strive hard never to forget that most money is lost when conditions are comforting and the outlook is good.
And, at this time in the market cycle, we really do not want to be buying businesses merely because they are ‘cheap enough’.
Harder to find a 'margin of safety'
It is in precisely this sort of market environment when it grows harder to find what value investors call the margin of safety – that is, the difference between the market price of an asset and its true worth, and thus the cushion investors have to compensate for the risks of owning that asset.
When margin of safety is scarce, both the upside we can extract from an investment and the insurance we have against its associated risks are low.
Achieving a suitable balance between risk and reward is the foundation of successful long-term investing and, by consistently viewing the stockmarket in these terms, investors are much less likely to be distracted by bouts of short-term exuberance.
These are dangerous times for investors precisely because they feel so comfortable.
Investment principles traditionally associated with 'value', such as patience, prudence and a dedicated focus on valuation and balance sheet metrics, can appear increasingly outmoded and unexciting.
Equally, the temptation to lower standards – or even to abandon them – in pursuit of the apparently immediate gains on offer can be strong.
By the same token, the risks of overpaying for investments is also higher and, as what you pay, not the growth you get, is the biggest driver of future returns, the seeds of future capital loss can be very easily sown.
A focus on fundamentals over froth may not be rewarded in the short term and yet, in the long run, it is the surest way to safeguard capital and ensure full advantage can be taken when it is not red flags but margin of safety, and thus investment opportunity, that are in abundance once again.