A Credit Investors Approach to the “Margin of Safety”

Everyone knows Warren Buffett’s two rules of stock investing:

• Rule #1 – Don’t lose money
• Rule #2 – Don’t forget rule #1

At Intrepid, we have adopted these rules wholeheartedly into our investment process, with a slight adaptation for investing in corporate debt:

• Rule #1 – Get paid back on time
• Rule #2 – Don’t not get paid back on time

Specifically, our credit research is designed to ensure the companies we invest in can pay down our debt from existing cash flow or, at worst, can maintain themselves in an excellent financial position that will allow them to execute what we call a “no-drama” refinancing in order to pay us back at the maturity of our notes.

That means the analysis we do is centered around the business fundamentals of the company and its ability to generate consistent cash flow – very similar to the research one would do when looking to make a long-term stock investment.

We start by looking for opportunities where we believe a company can easily pay off the debt we own through cash flow generation over the remaining life of the bond.

You could call that “Plan A” and the vast majority of our positions over time fall into this bucket.

But what happens when Plan A doesn’t work? When a thesis of a “painless paydown” or a “no drama” refinancing doesn’t play out due to macro or company-specific issues?

That’s where Plan B comes in – the margin of safety.

The margin of safety is a concept created by the famous investor (Benjamin Graham) and further developed in one of the all-time classic investment books authored by Seth Klarman (Margin of Safety: Risk-averse Value Investing Strategies for the Thoughtful Investor).

The concept relies on making sure you invest in opportunities where if things go wrong (whether based on things you can’t control or your own analytical mistakes), the margin of safety you implement in your investment process increases the odds that you don’t violate Warren Buffett’s rules above.

It’s a framework we see applied to equity investing all the time, but rarely see mentioned in regards to fixed income.

However, the idea of a margin of safety – something that increases the odds of our money getting paid back on time – is a core part of our underwriting process.

Below is how we apply the concept when looking for credit ideas.

The company’s willingness to pay us back on time

Ask any lending officer at a sleepy savings and loan bank, and they will tell you that the most important predictor of whether or not a loan gets paid back on time is the character of the borrower.

In our opinion, they are 100% correct.

As such, the first things we check for when determining our margin of safety are indicators such as:

1. The company’s track record of capital allocation. Have they made creditor-friendly capital allocation decisions in the past?
2. Investor Relations. Do they openly communicate the desire to keep leverage manageable and liquidity high? Do they meet with creditors to explain their plans clearly?
3. Incentives. Are their incentives aligned with making sure the company survives any potential stress? Is the founder's identity tied up in the business? Do they own a meaningful stake in the business that would be decimated by financial distress or a restructuring process?
4. Fairness. Do they exhibit a penchant for financial engineering or liability management “tricks?”

The answers to these questions take a long time to truly understand, and that's why we often follow companies for years before investing in them.

But they provide key insights into what sort of margin of safety may exist if our investment in a company’s debt doesn’t follow “Plan A.” We obviously prefer management teams and Boards with a high degree of character that also:

• Show a past track record of creditor-friendly capital allocation
• Openly communicate their commitment and duty to creditors
• Have large ownership in the business that they want to protect by not managing the company in an overly risky manner and are incentivized to do whatever it takes to avoid a restructuring process
• Don’t come from past jobs on Wall Street and thus are less tempted to extract value from creditors through financial engineering or liability management

On this topic, one of the strongest signals that a company can send that it is committed to paying us back on time is proving that it is willing to do so at the expense of its shareholders. For instance, when a company cuts its dividend in order to funnel more capital to debt repayment, that is something we value highly and certainly adds to our margin of safety. 

Even better is when a company has shown the willingness to raise fresh capital through a secondary stock offering with the proceeds earmarked for reducing leverage or making a refinancing transaction feasible.

This sort of liquidity "lever," if the company is willing to pull it, is probably the most attractive margin of safety we can have as creditors.

However, there are other important liquidity levers that we look for when fulfilling our margin of safety research on a new idea.

The company’s liquidity “levers”

There are too many potential liquidity levers to make a complete list here, but some of the more common ones we look for are described below. The key point to take away is that we want our companies to have as many liquidity options as possible to help them pay us back on time should we find ourselves in a “Plan B” situation. 

1. Undrawn revolver or credit facility. As long as it is undrawn or has ample excess capacity, this is a key source of liquidity for most companies and in certain cases can be drawn on directly to pay maturing debt or even buy back debt in the open market at a discount.
2. Secured debt capacity and/or unencumbered collateral. Relatedly, if the company has valuable assets (including hard assets like equipment and real estate or high-quality receivables that could be borrowed against) that are not encumbered by existing debt, the company can use these assets to raise new capital to pay off maturing bonds or loans.
3. Asset Sales. If the company has valuable business units or segments, these can be sold and used to pay down debt. In addition, companies may complete sale-leaseback transactions of owned real estate holdings to raise capital.
4. Other Holdings. Some companies own controlling equity interests in joint ventures or unconsolidated businesses where they have the ability to dividend money back to their parent to address pressing debt concerns.

As we do with the fundamentals of a company, we spend a lot of time separately researching and analyzing a company’s liquidity levers (including the company’s willingness to pull on them). We liken our approach to a kid looking for his gifts under the tree at Christmas: the more the merrier.

Other parties’ incentives

Finally, in addition to the role that incentives among the management team and Board of Directors have, other stakeholders’ motivations can, at times, influence the magnitude of our margin of safety –  either positively or negatively.

• Does another investor own a large percentage of the company’s debt? While we don’t like to rely on the kindness of strangers to get paid back, we do notice that when an investor has a large position in a company’s debt, they tend to be very supportive of the company in a refinancing process.
• Is the debt in question at a small subsidiary of the company but guaranteed by the parent? Even if the small subsidiary in question can no longer support its debt, if the more valuable parent company has guaranteed that subsidiary’s debt, it is unlikely the parent company will let the subsidiary default and thus trigger cross-defaults of its own direct obligations.
• Is the company controlled by private equity? Something that weakens a margin of safety is the existence of a private equity sponsor that controls the company. Private equity players often have the incentive to manage a company very aggressively and “go for broke” for a huge upside case at the expense of the prudent and conservative financial management approach that we prefer. In addition, when things go wrong, we find that these sponsors frequently resort to the financial engineering and liability management tricks mentioned above to extract value from creditors. As a result, we generally avoid investing in the debt of private equity-controlled companies.

Conclusion

In an ideal world, our corporate debt investments are all “Plan A” ideas. But since the world is far from ideal, it’s essential to think through “Plan B” and determine how well a borrower is prepared to fulfill their commitments if circumstances don’t proceed as hoped.

As we are always striving to follow Warren Buffett’s two rules above, the margin of safety on each and every one of our fixed-income holdings is an important factor in our research, analysis, and portfolio management decisions.

To discuss how a margin of safety can help buffer your fixed-income portfolio returns, contact our portfolio management team today.

Past performance is not a guarantee of future results.

Mutual fund investing involves risk. Principal loss is possible.

• Interest Rate Risk: When interest rates rise, the value of previously-issued bonds and other debt securities decreases. An increase in interest rates typically causes a decline in the value of the debt securities in which the Fund may invest.
• The value of your investment in the Fund may change in response to changes in the credit ratings of the Fund’s portfolio of debt securities.
• The risk of investing in bonds and debt securities whose issuers may not be able to make interest and principal payments.
• The risk of loss on investments in high yield securities or “junk bonds.” These securities are rated below investment grade, are usually less liquid, have greater credit risk than investment grade debt securities, and their market values tend to be volatile.

The Funds’ investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus contains this and other important information about the investment company. Please read it carefully before investing. A hard copy of the prospectus can be requested by calling 866-996-FUND (3863).

Intrepid Capital Management Funds are distributed by Quasar Distributors, LLC.