Weekend Reading 12/10/2021

Convertibles are an interesting asset class that can help boost fixed income returns in this low-rate environment. Convertibles can provide equity-esque exposure to the upside with bond protection to the downside.

One word of warning, recent convertible performance looks terrific but this is influenced strongly by Tesla (TSLA). As a mega-cap company and a frequent issuer, TSLA is a major component of the convertible benchmark.

Convertibles are relatively uncorrelated with other asset classes.

Convertibles fit well with investors looking for an absolute (rather than relative) return profile

By working with major banks, convertible investors (like Miller) can also devise synthetic convertibles, thereby broadening the investable universe.

• When this happens, an issuing bank (JP Morgan, Wells Fargo, etc) will offer convertible terms to the fund. This allows the fund to invest in a convertible for a company that might not otherwise have a convertible note on the market. The bank is certainly making a spread on the back-end but the fund certainly wins too.
• In this case, what is interesting is that the credit risk is effectively borne by the money-center bank, NOT the underlying company.
• During March 2020, Miller had a synthetic convertible with Wells Fargo on Delta Airlines (DAL).
  • At the time, Delta’s bonds were trading well off of par- remember it looked like many airlines could go bankrupt!
  • The convertible Miller held was tied to Delta’s stock on the upside. As long as Delta was a performing credit, the convertible was ‘at par.’ But Delta’s own bonds were FAR from par…
  • The difference was that Wells Fargo was the issuer of this synthetic convertible, not Delta.
  • Miller was able to redeem the DAL convertible at par

I’m generally opposed to taking unnecessary fixed income risk to chase a few extra basis points but I think the convertible space is an interesting niche. More to come here…

Goodwill and intangible assets are much more significant in today’s markets but there is no good way to report or analyze this data.

Should goodwill be amortized or impaired? Should goodwill be included as an accounting asset at all? There really isn’t a good way to measure goodwill!

“Most accounting is about recognising and measuring individual assets and liabilities, and the related revenues and expenses that are derived from changes in these balance sheet items. The insights this provides for investors are extremely useful and it facilitates analysis of key metrics, such as profit, cash flow, return on capital, and components of financial position. However, accounting data alone is not enough for investors to fully understand a business, even when supported by footnotes and the related explanations in management commentary. Investors also need information that directly relates to business value. We are not necessarily saying that companies should provide management’s valuation of the business, but rather that transactions, activities, and risks that affect value, and for which normal accounting metrics do not suffice, are reported such that investors are able to make their own value judgements.”

In particular, when I covered banks, acquisitive banks always had a ton of goodwill. When analyzing the stock, I would simply ignore goodwill and evaluated returns on Tangible Book Value. In the event that goodwill was ever impaired, that was viewed as negative (clearly someone screwed up if you have a write-down) but mostly goodwill was just ignored.

At the end of the day, the inherent value of a business is dependent upon its ability to generate cash. If that cash will be generated far into the future, then I think it behooves management & Investor Relations to develop clear, transparent metrics that can help investors better understand the future earnings potential.