Fighting Financials Portfolio Update - July / August 2024: Who Ever Said Credit Financials Were Dead… ! Towards Twenty >10% IRR Liquid Sub-Investment Grade Financials Credits

As of late July 2024, the Fighting Financials platform had reached its current cap of twenty active investment ideas, broadly diversified across geographies, size of issue and financials sub-sector.

Exhibit: FFL Key Portfolio Characteristics as of End-July 2024

(Source: FFL calculations)

The LTM ending July was also a positive period for “ARO Fund”, the live portfolio in which Andrew has the vast majority of his liquid net worth.

In the last twelve months ending July, that portfolio is up 18.2%. This is despite running a sub-70% net equity long-exposure, with the 30% balance split across credits, cash and the rare short.

The performance compares favourably to relevant indices, notably the FTSE All-Share Index (+9.3%) and the MSCI All-Country World Index (+15.1%), despite running materially less market risk and beta exposure.

Performance has remained particularly strong in August, in both relative and absolute terms.

Exhibit: ARO Fund Cumulative Return YE-July 2024

(Source: FFL calculations)

Longer term, funds managed by the FFL team have outperformed major equity indices. Going forward, we aim to continue outperforming major equity indices whilst incurring materially lower volatility/risk.

Exhibit: Unaudited 3-year returns, ARO Fund vs relevant indices

(Source: FFL calculations)

Into Year-End: On the Hunt for >10% Yielding Financials Credits

As we look to the remaining months of 2024, and with both the Federal Reserve and the Bank of England in recent days and weeks signally in their most explicit term yet their expectations for monetary easing, we wanted to review the opportunity in public financials credits, an opportunity set that is often overlooked and/or misunderstood.

In recent months, we’ve invested well in a handful of non-covered UK micro-cap financials credits, where investors could get paid 9-11% IRRs for cash flow producing businesses, where the asset bases - usually a pool of loans - were 4-5x the value of the total debt outstanding: i.e. implying double-digit returns for sub 20% LTV.

As these securities have continued to trend closer to maturity, whilst the companies have continued to perform to expectation the relative attractiveness of these opportunities has begun to fade (the securities in question now yield c.7-9% rather than 9-11%).

For that reason, as well as in search of more liquid opportunities, we wanted to take the opportunity to review the opportunity set in liquid financials credits.

The vast majority of the companies discussed have bonds yielding over 10% for what we deem to be a tolerable amount of risk – pending further research and investigation. A handful of the names discussed give us some initial cause for concern and we think investors should be cautious on these names.

To access the full 50-page report including our summary analysis of the twenty companies in question, professional investors can contact us directly at info@fightingfinancials.com. In the meantime, we highlight below some of our key takeaways from the report. We welcome readers' feedback.

Our Credit Financials Review List: Key Themes

Theme I: Banks - equity and credit markets telling competing narratives

• We find the pricing between various equity and credit securities within European banks to be occasionally contradictory.

• For example, where an equity price may imply distress, the price of the relevant senior and subordinated bonds for the same institution suggest strong going concern health.

• For the opportunistic investor, this presents for some interesting capital structure arbitrage opportunities.

Theme II: Large diversified banks do not feature

• Liquid bank credit securities yielding more than 6-7% also seem to be consigned to the historically “periphery” European economies and the specialist lenders.

• The larger, diversified banks do not feature across any of our high yield screens.

• Clearly, we’d expect the larger diversified banks to be perceived as having lower credit risk but we wonder out loud whether the current spreads makes sense.

Theme III: Debt collectors have significant dispersion on pricing

• The debt collectors and NPL purchasers have had several difficult years.

• What stands out for us today is that there is still a wide dispersion of yields and cash prices across the sector.

• Said dispersion – for us – does not correlate neatly to the underlying credit risks of individual issuers.

• We think this in turn presents an opportunity for thoughtful stock-picking.

Theme IV: Consumer lenders – funding structure is key

• The high-cost consumer lenders trade tighter in the context of one another, as compared to the debt collectors.

• That said, we think this homogeneity in pricing belies important fundamental differences in business models – notably funding cost and structure – that sets up said institutions to navigate the future economic landscape with different degrees of success.

Theme V: Healthcare assets – regulation remains key

• Healthcare real estate assets remain supported by long-term demographic shifts.

• Revenues are resilient and pricing power is likely to remain strong.

• However, regulation is key.

Theme VI: Real estate – Headline loan-to-value is only scratching the surface

• Both real estate equities and credits remain at depressed valuations in our view.

• Expected changes in the direction of interest rates have not prompted the majority of investors to step back into the market, and this could present opportunities.

• Headline LTV tells a very limited initial story. What really matters is yield stabilisation, underlying cash flow generation and reasonable assumptions about medium-term capital appreciation.

To access the full 50-page report including our summary analysis of the twenty companies in question, professional investors can contact us directly at info@fightingfinancials.com.

Until then, Happy Hunting!