Barron’s | Q&A Scouring the Globe for Cheap Stocks and Bonds
Jim Dondero is a hunter who knows that you can’t hit your target every time.
But Dondero and Mark Okada, who co-founded Highland Capital Management, a Dallas asset manager known for investing in distressed debt, shot a bull’s-eye last year—a 30% return—in the Highland Global Allocation Fund (ticker: HCOAX).
That’s a neat trick for a fund that is about 60% stocks, 40% bonds. Thanks in part to a big position in American Airlines Groupstock (AAL), which tripled, as well as some of its debt holdings, the fund’s performance was three times that of other funds in Morningstar’s moderate risk “world allocation” category.
Dondero and his team of managers can hunt the globe, bundling their fixed-income expertise with stock picks across industries. The fund strategy was more equity-focused until 2013, and that especially smarted in 2008, when the fund sank 33%, or about 10 points worse than comparable funds. Willingness to take risks in turnaround stories has paid off recently, but Dondero does play defense: He can short stocks, and has been known to hold a significant cash position.
As a firm, Highland took its lumps during the financial crisis, shuttering two hedge funds as investors ran for the hills. Today, Highland has roughly $19 billion in assets under management, and a focus on collateralized loan obligations (CLOs) and alternative strategies in hedge funds, mutual funds and other portfolios.
Excerpts of our conversation with Dondero follow: He is eyeing Puerto Rico debt, he thinks Europe investments have had their run and suggests other areas where investors might take profits.
Barrons.com: Describe your equity investing philosophy in the fund.
Dondero: We want adequate diversification without over-diversification. We hold about 120 positions in stocks and bonds. I am the main portfolio manager and have the biggest piece—about 25% of the assets—and six other portfolio managers have a piece of it. We meet weekly to discuss the macroeconomic backdrop and our thematic views of the market; everybody contributes between 10 and 15 ideas. If somebody has a good idea and puts a chunk of their portion of the portfolio in that name and it does well, it can have a material impact on the fund overall. We are more able to outperform, and we are holding the portfolio managers accountable. If a portfolio manager has a hot hand for a while, his portion of the portfolio will increase; if he has a cold hand for a while, his portion of the portfolio will decrease until he does better.
Q: What’s your outlook for the bond market?
A: The Federal Reserve is already signaling that if unemployment gets down to the 5%, 5.5% range, they are going to stop [quantitative] easing and stop having a zero-rate target. The party is definitely slowing down as far as fixed income…but it is not ending.
Q: How are you preparing for rising rates?
A: We’ve been positioned more toward floating-rate assets than fixed-rate assets for the last four or five years. In our fixed-rate bond portfolios, we keep them short: five- to seven-year maturities and less. The intention of floating-rate instruments is for the interest rate to reset on a regular basis.
Q: What distressed-debt situations do you like?
A: We own Texas Utilities bank debt and mezzanine debt in the Global Allocation Fund. TXU Energy was acquired in a private-equity deal [in 2007, with KKR, TPG and Goldman Sachs]. It was a leveraged buyout that stumbled, but it is getting back on track. TXU will go through a restructuring, and that will be good for the senior bank holders and even some of the mezzanine TXU debt.
Q: What bond investments are you interested in?
A: We don’t own Puerto Rico municipal bonds. But we think the risk-return is interesting now, with yield in the mid-high teens including tax benefits and appreciation. The government is making substantive changes in pensions and reimbursements. But there still have to be some more severe readjustments. We think it could get worse before it gets better.
Q: What about Europe?
A: We think Europe continues to slow down. I think European equities have played out over the last six months and have a few more months to run, at most. That pertains to high-risk debt also. You are seeing shrinking credit demand, and when the European Central Bank starts regulating the banks in the fourth quarter, there will be more pressure on lending. The strong currency is crimping manufacturing in Europe. The euro and Europe’s economy are vulnerable.
Q: Do you still like American Airlines stock?
A: We bought AMR equity when people were uncertain whether the merger with US Airways was going to happen, and whether or not the new management team could compete with Delta Air Lines (DAL) and United Continental Holdings (UAL) effectively. That has borne out more quickly than we expected. The merger went through and American is very quickly approaching the efficiencies of Delta and United.
Q: Have you taken profits?
A: A little bit, yes.
Q: What have you been buying?
A: One stock we like a lot is K12 (LRN). The market cap is $880 million. They manage charter schools across the country. Michael Milken has redirected his efforts in retirement toward education; the Milken family owns just under 5%, and we own just under 5% across all our funds. We were able to buy when K12 missed fourth-quarter earnings. It fell 40% in September based on missed earnings, but we were able to buy it in the $17-$18 range. It is in the $22 range, and we think it can get back to $30 by the end of the year. It is not losing any schools, and keeps winning mandates from municipalities outsourcing charter schools. It grew a little less than expected last fall, but it is still growing.
Q: And the valuation?
A: It is cheap. It is 5.5 times Ebitda [earnings before interest, taxes, depreciation and amortization], which is very attractive relative to its historical multiple of nine times Ebitda, and peers are trading at seven to eight times Ebitda.
Q: Some for-profit education companies have struggled to re-establish their credibility.
A: K12 got tainted when the for-profit education stocks had two miserable years. The government thought there was fraud and abuse…but anything that was education-related and for-profit traded down materially. One opportunity we found was DeVry Education Group (DV), but the stock has almost doubled from its lows.
Q: What do you like about Spirit Realty Capital (SRC)?
A: The dividend policy. Other real-estate investment trusts that have been around for a longer time with a more consistent history will trade on a 4% yield. Spirit yields 6.1%. As the yield converges with other REITs, investors should be willing to pay more for it. There is no reason for Spirit to have a much higher yield than other similar players in the market. It is a good, solid, value play.
Q: Why the discount?
A: Spirit went through an ugly restructuring a few years ago, and it is still somewhat misunderstood. It was a highly levered company. It restructured as a REIT and merged with another REIT. So that is why it trades with a much-higher dividend yield than other REITs. We bought it in the $8-$9 range, and it trades near $11. We expect it to go to $12-$14 over the next year or so.
Q: Another name you like?
A: Staples (SPLS), the big-box Internet retailer of office supplies. They have the best online business, and the best catalog versus Office Depot (ODP), which merged with OfficeMax. Staples is shrinking its store base, shrinking its size, and building its Internet business. With $24 billion in sales [and] 12% free cash flow off its sales base, it pays a 3.7% dividend, and it is buying back 8% of its stock every year. A lot of value guys bought Staples last year. The stock went from $12 to $17 and then retailers got hit at the end of the year. Staples was smacked down. We owned it, and bought more recently.
Q: And Staples is cheaper than the competition.
A: It trades at about 5.1 times enterprise value to Ebitda, while Office Depot is about 7.1 times EV/Ebitda. On a price-to-earnings basis, Staples is 8.3 times versus 12.4 times for Office Depot.
Q: What did you learn during the financial crisis?
A: There has to be a match between the investor’s commitment to the fund and the illiquidity of the assets the fund buys. A run on the bank can kill you, which is what happened to Lehman Brothers. A lot of hedge funds—we had a couple—learned this lesson. Everybody is much more diligent about risk management today than they were.
Q: Any future predictions for the hedge-fund business?
A: I think they all get registered. They all end up like closed-end funds, subject to Securities and Exchange Commission regulation. Hedge-fund performance has really lagged.