Portfolio Moves: Taking Risk Off, Being Patient
February 20th, 2009 by 
James Cullen
In my last portfolio repositioning in July 2008, I first made the decision to aggressively move up in capital structure, both in terms of asset allocation and how I allocate time analyzing securities. This is a decision I have regularly revisited, but with how the macro environment has deteriorated since, my preference for debt or preferred has remained. As Mohamed El-Erian points out, government involvement invariably comes at a cost to shareholders. What he leaves out, and others have focused on, is that most government capital injections effectively subsidize an institution’s debtholders. Better to be there, in my opinion, during times of trouble.
Last week, I made my first change since July. Since then, my only investments have been in Primus Guaranty stock (PRS) and debt (PRD) – primarily the latter – and that has worked out well. In that time, I am up about 40%, while the S&P is down more than 35%. The entire time, however, the risks to the investment grade universe have grown. My estimate of a peak loss rate used for Primus’ credit default swap portfolio has risen from 1.07% to 1.52% as of the most recent quarter, and the sharp rise in the overall value of my holdings has reduced the future expected returns.
One contradiction I’ve had to deal with for several months is that as my tone was negative, I was still very heavily invested in Primus. Last week, I decided it was prudent to increase my cash balance and take some risk off the table, and I sold two-thirds of my PRS holdings. With the stock below my selling price, I am considering buying some or all of it back. At the same time, I am also weighing the possibility of further reducing my exposure to Primus to increase cash holdings.
Where am I looking to put money to work? My disposition toward the debt side is still in tact; the returns to be had there are (in many cases) equal to or better than the returns typically expected from stocks. The problem is that much of the high-yielding debt is financial issues of low quality, and on the equity side there are plenty of energy MLPs which will see earnings follow energy prices off a cliff – likewise with REITs. Consumer staples might offer relatively safe earnings (though Doug Kass seems to disagree), but they also have rich valuations relative to profitability, which appears to leave little room for decent future returns.
While sitting on my hands the last few months has worked, I’m beginning to feel a more active stance is appropriate. With a comfortable year-to-date results cushion to work with, I have the ability (for now) to be patient and look to strategically press my lead. “Margin of safety” is still the central requirement I’m working around, and perhaps another washout on the equity side will finally give a fat pitch to swing at.
Chart, Primus stock (PRS)
Chart, Primus debt (PRD)
Subscribe to our feed using your favorite service:
Disclosure: I still own both PRS and PRD.
See more Financials, James Cullen, PRD, PRS, Stock Market | 
February 20th, 2009 at 12:59 pm
In the MLPs arena, there are several with contracts hedged for a couple of years (i.e. LINE, VNR, BBEP). They are probably going to reduce the dividend but not as much as current yields sugest. Plus they provide good protection against inflation that could become a concern a year from now
For example, BBEP has a 30%+ yield and the estimates are that at current prices they will have to reduce it 20 to 30%. That still provides a very good 20%+ yield. The hedges for 2009 and 2010 are just good, but for 2011 and 2012 are excellent. This has become the second largest position in Baupost/Klarman portfolio.
February 24th, 2009 at 7:44 pm
James,
Overall a nice analysis and congrats on the Primus trade.
This market has become a traders market with gains going to those with either an appetite for higher risk, short term trading or both.
I am interested in your thougths on a long-term value play, either debt or equity.
Ideas?
February 25th, 2009 at 3:31 pm
Coach,
If the PRD bonds are money good after running off the CDS portfolio (6 years), you’re looking at a yield-to-maturity of 26%.
On the debt side, I am looking at a handful of bank trust preferreds, as well as a convertible issued by a REIT. For equities… a couple broken stocks with good brands, as well as companies that will benefit from less competition on the flip side of the cycle.
More to follow soon…
February 26th, 2009 at 5:31 am
Excellent work on PRD, James! Making any money in this environment is impressive, but outperforming the S&P by 75 percentage points is remarkable.
I was thinking about how hard it is to invest in this political climate, with so much relying on the whims of the government; because, it’s so hard to predict the knock-on impact from government legislation. My recent example is GPRO, a NAT-blood testing company that I’ve been in and out of for years, ever since its IPO. Great conservative management, strong cash generation, strong balance sheet, buying back stock, not reliant on an expanding economy, etc. It recently had decent earnings and a decent outlook (stock did nothing in response). So, I’m thinking about starting a position in the stock and I read tonight that Obama’s going to strip tax deductions for charitable contributions for the ‘wealthy’. Now, GPRO does a lot of business with the Red Cross, and in a prior cycle, when Red Cross had slow donations, it had a marginally negative impact on their blood-testing efforts, and by extension GPRO. So, now I’m wondering whether Obama’s new tax hikes are going to hurt the Red Cross and this blood-testing company by extension. It’s just a really absurd process to have to go through.
March 13th, 2009 at 2:03 am
[...] A few weeks back I wrote about selling off portions of my holdings to raise cash. This turned out to a timely decision, as even after the rally of late, the S&P 500 is still down 13% from that point. My present drawdown is only 2.5% though, thanks to a combination of taking some risk off the table, as well as redeploying cash last Friday into Entertainment Properties (EPR) convertible preferred stock. The Vanguard REIT index (VNQ) is up 21% in the last week, and my specific class of preferred stock is up somewhat more than that. All in all, I am left in a decent position with holdings I feel relatively comfortable about. [...]