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When stocks and bonds send mixed messages, these investors sense opportunity

Date: Wednesday, May 4, 2016
Author: News Release

During times of heightened volatility in financial markets, stocks and bonds of the same company can often tell investors very different things.  A falling stock price may be suggesting a company is going out of business, while the bond is indicating there is little bankruptcy risk, and vice versa.  It’s been an exceptionally wild ride in Canada in recent months because the country is so resource oriented, and that’s created a number of investment options for Brandon Osten, chief executive at Venator Capital Management.


“There are always little corners of the bond market you can dig into, but we don’t see these types of opportunities every day,” he said.  The portfolio manager runs the Venator Income Fund, a long-bias North American yield strategy that was up 3.3 per cent through the first three months of 2016, and other mandates, with co-manager Stephen Andersons.


In the case of Precision Drilling Corp., while the stock was bouncing back in recent months, its March 15, 2019 bonds (6.625 per cent coupon) were trading at just 65 cents on the dollar.  “If the stock market was right, then this bond should be priced in the context of the high yield market, which would have put it closer to 90 cents,” Osten said. “We saw a lot of equity value backing those bonds, and didn’t think Precision was going bankrupt.”


Not only does Venator consider Precision a great operator, but the energy services company spent a lot of money upgrading its fleet during the previous cycle.  As a result, Osten noted that most of its rigs are now Tier 1.  “If the oil market takes fiver years to turn around, the only rigs you’re going to see operating are Tier 1,” he said. “They will be a survivor, but I wouldn’t want to be a company that predominantly has Tier 2 rigs, unless oil bounces back to US$80 per barrel in the next 18 months, which we don’t think it will.”


The opposite situation played out in the pharma sector.  The high-yield debt of both Valeant Pharmaceuticals International Inc. and Concordia Healthcare Corp. was relatively healthy compared to what the stocks were indicating.  In this instance, the high-yield bonds were relatively small issues at the junior end of the capital structure.  Osten noted that Concordia’s October 21, 2022 bonds (9.5 per cent coupon) never got below 95 cents, and Venator was buying Valeant’s August 15, 2018 bonds (6.75 per cent coupon) at around 90 cents.


“That suggested the companies were not the bankruptcy risks the stocks suggested,” he said, noting that they were both trading at 3 to 3.5 times earnings. “The bond market was saying it didn’t think Concordia would trip any operating covenants for the next six years.”  So if the company is still around then, Osten noted that its strategy will likely have played out and a lot of debt would be paid down.


Venator also owns Concordia stock in another portfolio, and with rumours recently surfacing of a potential takeover, Osten expects the share price will likely be decoupled from the fundamentals for the next six to eight week or so, while this situation sorts itself out.  Prior to the buyout speculation, the stock was trading at roughly 4x free cash flow, based on management’s guidance.  The issue that concerned investors was its debt-to-EBITDA ratio around 6.


Osten noted that most investors consider 5-5.5x the danger zone.  However, he pointed out that a while a typical company spends 10 to 20 per cent of its EBITDA on capex and has a tax rate above 30 per cent, neither applies to Concordia.  Venator felt that a 5.5x debt-to-EBITDA ratio for Concordia was the equivalent to around 3.5x for a manufacturer or retailer.


“We weren’t as scared away by the leverage as other people would have been,” Osten said. “The other thing that you have to contend with is the political situation in the U.S., which from a public standpoint is quite negative.  But I don’t think a lot of people, including the politicians, really understand how their own system works.”


He noted that there is a heavy focus on list prices, something Osten noted that nobody ever pays close to.  “That is just one of those misconceptions in the market,” Osten said, adding that 60 per cent of the company’s business is actually outside the U.S.

Brian Viveiros
Director of Sales
Venator Capital Management Ltd.
2 Bloor Street West, Suite 901
Toronto, ON     M4W 3E2

D:  647.361.8549
C:  647.280.3307