Q: What is your investment philosophy?

A: We believe that the high yield category is one of the best total return asset classes in the longer term. Whatever the duration of the bonds, this asset class displays less volatility than stocks, and offers higher income compared to the ten-year treasury or investment-grade bonds.

Our philosophy is to thoroughly research and understand every credit that we consider for investment, because we believe it is far easier to make money if we don’t lose it. Therefore, our objective is to protect principal and generate returns with less volatility.

Q: What is your investment strategy?

A: The overriding theme is to limit volatility. Consequently, we steer away from convertible bonds, emerging markets bonds, preferred stocks, pick bonds which are pay-in-kind bonds which pay in incremental debt rather than cash interest, zero coupon bonds and even common stocks, that historically have shown a great deal of volatility. We thus try to reduce volatility relative to equity markets while managing a high-yield bond portfolio.

Therefore, our strategy differs from that of many managers in the high yield space that add a lot of beta to their portfolio, thereby making them as volatile as equity portfolios.

Within the high yield sector itself we will limit investments in businesses that are cyclical in nature like steel, paper, chemicals, and oil. In cyclical companies, we cannot predict earnings and cash flow streams on any reasonable basis. Whereas, we are looking for companies having reasonably predictable earnings streams so that they can take those cash flows and amortize the debt on the balance sheet. We also avoid airlines, automobiles, homebuilders and restaurants, and are very limited in our selection of companies in the retail sector.

Another focus we have is to look for companies that have an exceptionally fiscally responsible, management team that can articulate a roadmap to deleveraging the balance sheet. We thus look for management teams that are in a debt pay-down mode. We look at only those industries that we can understand and analyze from a logical perspective, such as supermarkets, healthcare, energy companies, and gaming companies, and avoid technologically driven companies as they are far more complicated to comprehend.

Consequently, when we combine the fact that we eliminate the equity types of securities dressed up to look like debt securities, along with avoiding the cyclical stocks and focus on debt pay-down type stories, we end up having a unique strategy within the high yield asset class.

Q: Can you walk us through your research process?

A: We look for companies that are in debt repayment mode. For example, suppose that a company has a term loan with JP Morgan, which requires that a certain percentage of that debt be paid back on an annual basis. Our model companies would be those that have the free cash flow to service the amortizing debt schedule on that term loan. Such companies would then cause rating agencies like Moody’s and S&P to seriously consider upgrading them. We are basically looking for balance sheets that are improving and situations in which the management team is being rewarded with an rating upgrade.

Furthermore, we rely mainly on our own research to generate ideas. We are totally independent of the sell-side and build all of our models internally. It is important for us to go and visit not just the top management on their own campus, but dig deep into the infrastructure and get to lower level employees who will be less guarded with company information. We keep in constant touch with management teams.

We model our companies on three potential scenarios, namely, the base case, best case and a worst case scenario. The worst case would involve an assumption that a company takes on any incremental debt they might be able to use, at a future date. After we lever up the balance sheet, we test lower EBITDA levels, or earnings before interest tax depreciation and amortization, whereby the company will either bust the bank or high yield bond covenants or may force the firm into bankruptcy.

This however, is just a way to stress test each and every credit. We approach every year with the mindset that we want to build a portfolio whereby the yield that we display at the beginning of the year, based on the current yield, can actually be earned.

Ours is also a hands-on type of research. If we see a company in which the physical property (the collateral for bondholders) doesn’t look well maintained we will photograph or video tape it and send it to the management team, or visit them to show our findings. We give suggestions for improvement. For instance, we might own the bonds of a restaurant chain; if we walk into one of the restaurants and find that the restrooms are not spotless, we videotape or photograph it, ship it to management and demand that things be fixed.

Our research process is therefore very aggressive and pro-active. As bondholders, our approach is that we own the property and expect management teams to maintain the value of the bondholders’ collateral. If the management team does not share that perspective, their bonds have no place in our portfolio.

Q: Can you give some historical examples that illustrate your research process?

A: The Venetian in Las Vegas, better known as the Las Vegas Sands, which at the time of construction was one of the largest of such projects in the world. We were the lead buyer of that particular deal and oversaw every stage of the construction process to make sure that the property was on time and on budget. Furthermore, based on our expected cash flow generation we knew they would eventually be in a position to de-lever the balance sheet.

Our intense research was fruitful. The company issued bonds originally at a 12¼ rate, then 11 some years later, and recently a 63/8 coupon so the market now has rewarded the company. The project is now one of the better cash flowing properties in all of Las Vegas.