While much ado is made of the science that goes into fund manager research, real assessment puts comparable weight on the art as well according to investment leaders.
While financials and materials dominated trades leading into 2024, the popularity of other sectors like healthcare and information technology followed generational, and even demographic, lines.
Credit investing more art than science
Many people would assume that credit investing is rigorously, even wholly, mathematical, but Harry Sugiarto, portfolio director, multi-asset credit at ICG in London, begs to differ.
“Certainly for us, it’s more art than science,” he says. “Clearly, there are certain processes you follow, models you run, diligence you undertake, but in and around that, there is a clear view on how you expect a company to perform; how you believe a management team or a financial sponsor will behave; does the owner have the capacity to support the business? Those assessments are very hard to capture in a machine, or a model.”
What Sugiarto is saying is that ICG portfolio managers like to meet issuers, face-to-face. “For us, it ultimately comes down to a decision by the investment committee or a portfolio manager about whether we think a company will pay us back – whether we think it’s a high-quality company, whether you think its sponsorship is strong, or not.”
Naturally, he says, a great deal of the information that ICG needs to make that decision is in the accounts, and other financial data to which it has access. “We very much like to get to meet our issuers face-to-face, because that is always valuable, it is like any other relationship, and you do feel that you can ‘read’ people better in that situation.
“But having said that, the fundamental question, what we’re always asking, is will an owner support the business? Does it have the capacity to support the business? Now that’s something that you can ask, face-to-face, but actually, you might not always get a straight answer. That’s something that you can somewhat deduce because you understand the owner’s incentives, you can see into their financial firepower, and you may have previous experience of other investments with them. All of that assessment – the objective part and the subjective part – goes into the decision to invest or not, but we do feel it is more art than science.”
The pandemic years provided an “interesting test” of this, Sugiarto says. “When we could not get meetings – that is, when we physically could not attend meetings – it was inefficient, and annoying, at first, but we found that there were still ways to get things done. Clearly the world has adapted to a virtual world. We will always prefer, when we can, to be face-to-face on a deal, but we did find, in the virtual environment, that we didn’t necessarily lose out in terms of our ability to gather that type of information, or make those decisions.”
The “red flags” on buying an issue are still the same, he says, no matter the medium of the conversation. “We always take the approach that we are simply one stakeholder in the business. We’re lending a company money. The other primary stakeholder, or representation in the company’s balance sheet, is its ownership. So, what we value the most is alignment of interest. We value high-quality sponsorship; we believe that deep-pocketed financial sponsors that can run businesses well, will also be motivated to support the businesses we’re lending to. Where we feel there is misalignment of interests, that’s the biggest red flag to us.”
Investors often seem to believe that managing a credit portfolio is all about avoiding losing situations, compared to an equities fund manager, who’s trying to find winning situations. But Sugiarto says that avoiding losses is “only one part of the credit story”.
“Avoiding defaults is a clear way to preserve capital for your clients, and to outperform. But we work in a market like any other, in which assets can be mis-valued, both to the high side and to the low side, and finding those mis-valued assets on the low side can very much help to drive performance,” he says.
And the nature of the credit class means that a good manager is not only looking for mis-valuation, but mis-rating. Like any credit manager worth their salt, Sugiarto chooses his words carefully on this topic – but the fact is that mis-valuation can often spring from mis-rating, and any active manager will trust its team’s “shadow rating” work against that of an issuer’s (or issue’s) rating from the ratings agencies.
“The rating agencies are hugely influential in our industry, and much of the behaviour of market participants is driven by the ratings agencies,” Sugiarto says. “But most credit managers would tell you that they use the credit ratings agencies as a starting point, but they certainly don’t rely on them. We look at the ratings agency viewpoints all the time, as everyone in our industry and what I’d say is that there are several potential blind spots that we understand, and that we can value, that aren’t necessarily part of their framework. Part of what we see as our proprietary advantage is that we go much deeper into the investment, to arrive at what we believe is the true rating – and sometimes, the arbitrage between that and the broader view in the marketplace, based on the agencies’ rating, can be a huge source of alpha.”
Sugiarto stresses that this is not a criticism of the ratings agencies – simply that a credit manager is thinking about other and different things than they are.
“It goes back to what I was saying earlier, about the fundamental things that we’re always asking ourselves about a transaction. Who’s backing the company? Do they have financial firepower? Do they have dry power? What’s their motivation? Those aren’t necessarily things that ratings agencies will think about, because it isn’t part of their job. So, there is a huge intellectual disconnect between how we see credit and how it’s rated,” he says.
Asked what most worries him about the investment environment as we almost complete the first quarter of 2023, Sugiarto gives a quite surprising answer: “that the opportunity goes away before I’ve had the chance to fully exploit it.”
Invited to unpack this, he says that all of the economic, fiscal and geo-political influences on the credit market have combined in a period of very extreme dislocation.
“It takes time, and it takes a lot of analysis, to fully research that dislocation to find the opportunities and then put them in the portfolio,” he says. “Clearly, we’ve had a very strong start to the year in 2023, but there is always that risk that we haven’t fully captured the opportunity from day one of its emergence, because these things take time.”
