30 Jun Stocks Matter (Q2-13)

Credit analysis is a dynamic process that involves quantitative and qualitative factors that are fundamentally concerned about underlying asset value. The ability of a borrower to repay its debt is dependent upon the future market value of its assets. If the assets of the borrower have sufficient market value, the borrower can easily raise cash it needs by selling off a portion of its assets. If the assets are immovable, then the borrower can sell them indirectly by issuing additional equity or debt. In any case, it is the market value of the borrower’s assets that determine the borrower’s value, and by extension the value of its debt which constitutes a claim against such assets.

Equity markets, which are more liquid and transparent than the inefficient and opaque corporate credit markets, are an excellent source of information and, because of their ubiquity, provide a relatively quick and easy method to estimate underlying asset value. Equity markets are also important barometers of investor sentiment and perceptions about a given industry sector. Equity market volatility can provide a check on whether a particular company or sector is out-of-favour, and if underlying asset values are stable. For these reasons, credit portfolio managers should pay attention to stock prices even when their borrowers are private. The liquidity and news flow on public equities means that the active monitoring of a borrower’s publicly-traded peers can provide insight into sudden or unusual industry activity and key events that could impact credit fundamentals. In the context of the current rate environment, equities may have even greater predictive power for credit investors. According to Barclays Capital, over the past twenty years stocks have been more likely to rally when rates are rising, and strong equity markets tend to support corporate credit prices by reducing default risks.

Stock market data is very useful in calculating a benchmark enterprise value, a proxy for a company’s underlying asset value. Whether determining the enterprise value for a private company, or validating the enterprise value for a public one, the analysis begins by choosing a comparable set of publicly-traded peers based on size, geographic, and industry criteria. Then one or more key valuation metrics must be selected. For simplicity sake, most credit investors calculate enterprise value based on a multiple of some observable quantity, usually revenue or EBITDA but these traditional multiples are not always useful (or relevant) for certain types of companies. At TEC, where loans are strictly based on our opinion of the borrower’s assets, we assess asset values directly through audits of receivables, expert appraisals of inventory and fixed assets, review of intellectual property, and discussions with customers, suppliers, competitors, and liquidators. However, we also gain insight into the broader market’s opinion of firm asset value by looking at key valuation multiples of comparable peers that vary by industry. Some of the non-traditional valuation metrics we have found to be especially effective in determining benchmark enterprise values for companies in our portfolio include:

Industry Sector
Key Valuation Metrics to Calculate EV

Oil and Gas
EV to Proved and Probable Reserves (BOE)

Mining
EV to Measured and Indicated Resources

Software
EV to Recurring Revenues

Media
EV to Subscribers

Financials
EV to Book Value

Multiple-based valuations reflect the mood of the market, which means value estimates can sometimes be too high when stock markets overheat. Using the equity market to determine asset values relies on a belief in market values and the efficiency of the market to reflect all available information in equity prices. But an efficient market is not the same as a rationale one, and as the great financial analyst Benjamin Graham once proposed, the price of every stock contains a “speculative element” driven by sentiment and emotion, fear and greed. The speculative element in pricing is prone to extreme swings that can distort equity valuations and give false comfort to lenders who derive asset values only from the market price of the stock of their borrowers or peers.

Equity markets provide valuable information to credit investors about underlying asset valuation, peer comparisons, industry trends, and market sentiment. Lenders that ignore the cues provided by equity markets do so at their own peril.

Excerpted from Third Eye Capital Management Inc.’s Q2 2013 Investor Letter.