Jack Meskunas, managing director of investments at Oppenheimer & Co, examines what the bond market reveals about the true health of companies, and why captive insurance portfolios deserve active management over passive index fund exposure.
The securities industry is filled with sayings, adages, and maxims about when to buy, sell, or hold securities, and who represents the ‘smart money’ in the investment business. For good reason, as following the leader has frequently been a profitable strategy as the smart money always seems one step ahead of the masses.
While captive insurance companies generally do not speculate, their equity accounts can be subjected to large swings in value if invested passively in index funds (think S&P 500 and NASDAQ 100) that are overweighted in stocks that can run hot and cold at times.
As far as the overall market is concerned, massive money has been made by investors recognising trends and being ‘ahead of the crowd’ into the hottest areas of the stock market, whereas speculators ‘late to the party’ have often suffered significant losses.
One period that comes to mind was the dot-com bubble that started in the late 1990s and ended in a burst of flames in the spring of 2000. Early investors in the internet stocks of the mid to late 1990s saw a megatrend forming. The internet was new, and while few companies were using it for business, it became apparent that eventually every business was going to have a website, and the internet expenditures would ultimately be justified. Many investors and pundits are thinking along the same lines today when it comes to AI and the amount of money being spent on development and deployment. In the late 1990s, while hundreds of companies went out of business in the dot-com bubble, some survived and some ideas were rekindled years later with substantially similar business models that were written off as the bubble burst in 2000. I think about Pets.com, so let us discuss what happened.
Pets.com, because pets can not drive…
Pets.com went public about a month before the bubble burst. The stock almost doubled in price before becoming worthless and bankrupt. Their business model was to sell products for pets on the internet and they had over 12,000 items. Amazon owned 43 per cent of the company. While their sales increased 16-fold, most people say they lost money due to their high marketing budget, but the real reason was that in the year 2000, e-commerce was immature and internet penetration low at the time. Shopping on the internet was a novelty, not the normal course of business.
A company with a strikingly similar business model, but better timing, is Chewy. They went public in 2019 with a US$1 billion offering. The company is now worth over US$11 billion. I believe the biggest difference in the two outcomes was the stage of development and availability of the internet, not what or how they sold.
Follow the money
When I am putting together portfolios for captive insurance companies, I try to make sure that I know what I own and why I own it. Part of knowing what to own is to see how many sophisticated investors are in the same stock. This is easy to do on my Bloomberg Professional as I can see all the major holders of any equity. For some companies or industries this may make little difference, but in highly technical sectors, the institutions that really know that space place their assets more carefully.
Brilliant bonds
But an even better way to find out what is really going on in a company or an investment is not to look at the stock price or the stock market, but look where the really smart money is invested: in the bond market.
Just today I was looking at the shares of a business development company (BDC). These high-yield private lenders have been getting pummelled recently due to declining interest rates and slanderous comments from some chief executives of traditional banks. One even called them ‘cockroaches.’
While many BDC share prices are down 25 per cent, looking at their bonds (in many but not all cases) tells another story. Many of them have bonds that have been rock solid, still trading around par (100 cents on the dollar) with half of the yield of the common stocks.
The bond investors, almost exclusively institutions in this specialised space, know that these companies appear rock-solid and they are not selling into the white noise of the talking heads on cable news, or reacting to some jilted chief executive ‘talking his book.’
Stupid stocks
Continuing with the discussion of BDCs, if the bonds say ‘hold’ why are the stocks down 10-25 per cent? Unlike bond investors, stock investors in the BDC space are about 80 per cent small retail investors, enticed by the juicy yields (10-20 per cent) but with no real knowledge of how the companies work or what they own.
Subsequently when they see negative stories on the news about ‘private credit’ they sell with the same lack of knowledge and foresight with which they bought.
The investment community has an adage for this: it is called the ‘odd-lot theory.’ This theory states that odd-lot buyers (small investors who buy less than 100 shares of a stock) are retail investors and the theory has a simple premise: retail investors are always wrong. Ouch! That said, there is a lot of truth to this.
Active intelligent investing in equities and bonds
I continue to recommend actively invested stock and bond managers for captives via separately managed accounts (SMA) rather than exchange traded funds (ETFs) or index funds. There are many reasons for this. Professional asset management is best executed by trained portfolio managers. They have experience, a track record, and they know why they bought what they are holding, and the reason they bought it. A random nasty comment from a jilted or jealous chief executive who feels other businesses are encroaching on ‘his’ territory is not going to have these professionals charging for the exits.
Captives deserve good performance, but it does not stop there. They deserve reasonable risk-adjusted rates of return, and overall lower volatility that is currently found in the major index funds. It is interesting to me that recently Vanguard noted to investors that according to the Investment Company Act of 1940 (a set of laws relating to mutual funds) their index funds are considered ‘non-diversified’ and that a large swing in the value of some of their top holdings, or even just one of them, could adversely affect the value of the fund.
Imagine the surprise people who read that must have felt when (if they dug deep enough) they discovered that their ‘diversified’ S&P 500 index fund had close to half of their money in 10 stocks, and that the ‘diversified’ NASDAQ 100 index fund had over 70 per cent of their money in their top 10 positions. That is no longer investing; it is speculating on a handful of technology and AI companies. While individuals are free to speculate, a captive insurance company should be more prudently diversified and invested.
Just say no
When presented with a recommended equity allocation in index funds, a captive owner should ask ‘Why?’ If the answer is simply ‘You can not beat the market, so just own the market’ you are speaking with the wrong adviser. While I work with many managers that consistently beat the overall market returns, few captives have an investment policy statement (IPS) that says they need to beat the S&P 500. However, every captive IPS I have seen has a goal of preservation of capital, consistency of returns, and a reasonable rate of return for the risks incurred within their portfolios.
This article was written by Jack Meskunas a Financial Advisor with Oppenheimer & Co. Inc. who can be reached at (203)975-2084 or jack.meskunas@opco.com. This article is not and is under no circumstances to be construed as an offer to sell or buy any securities. The information set forth herein has been derived from sources believed to be reliable and does not purport to be a complete analysis of market segments discussed. Opinions expressed herein are subject to change without notice and do not necessarily reflect those of the Firm. Additional information is available upon request. Oppenheimer & Co. Inc., nor any of its employees or affiliates, does not provide legal or tax advice.
