FUNDVIEW-Using bonds to find mispriced equities

By Edward Krudy

NEW YORK, July 15 (BestGrowthStock) – Peter Andersen had his “aha
moment” while managing junk bonds nearly a decade ago.

He asked a stock analyst for his view on a company and was
so surprised at how different his opinion was that he thought
he’d got the name wrong. Since then he’s been developing a
system to identify mispriced equities using bond analysis.

The system is credible, explains Andersen, a portfolio
manager at Congress Asset Management in Boston, only if you
believe that bond analysts, with their focus on a company’s
cash flow, have a better insight into a firm’s health in the
present moment than equity analysts, who build growth estimates
out several years into the future.

From Andersen’s vantage point, corporate bonds can
sometimes be seen as a leading indicator for equities.

“They (bond holders) are more upstream to the cash flow,”
he said. “If the bond holder starts saying that the bonds are
getting paid off more rapidly or serviced with 10 times the
cash flow, there is going to be excess cash flow that’s going
to eventually head to either the equity holder as a dividend, a
stock buyback (or) strategic acquisitions.”

Andersen uses software that identifies companies whose
bonds returns are out of whack with the returns on their
stocks. That’s when the fundamental equity analysis begins.
Based on the outcome of that process, he buys stocks whose
returns are lagging bond returns and shorts those that are
outperforming.

The strategy lets him exploit information inefficiencies in
the corporate bond market where a close knit community of
traders and over-the-counter deals are still the norm. Getting
an edge on information that has not been widely traded is more
likely there, he says, than in anonymous, highly liquid equity
markets, where information is traded in milliseconds.

“That personal interaction often leads to information that
would not be written down in an analyst’s report,” he said.
“With that personal information also comes information that can
be reflected in the bond prices earlier than in the equities.”

Congress has offered the strategy for five years in managed
client portfolios and has about $25 million dedicated to it.
Andersen wants to increase that to $2 billion to $3 billion.

The strategy has a cumulative 5-year return of 9 percent
over a period when the S&P 500 returned around 1 percent on a
total return basis. Congress has about $5 billion in assets
under management.

The strategy has led Andersen to some obscure names. In
recent weeks Andersen has picked up Sally Beauty Holdings Inc
(SBH.N: ), a beauty supplies distributor, which he says is paying
down debt rapidly, is opening new stores and is forecast to
grow at 40 percent while trading at only 10 times its projected
earnings.

“It meets all the requirements for an equity investment
that in my opinion is undervalued and is moving totally against
the tide.” The company is also nearly 50 percent owned by
leveraged buy-out firm Clayton Dubilier & Rice. “You’ve got
that whole horse power behind you for free,” said Andersen.

Andersen has also recently acquired International Coal
Group Inc (ICO.N: ), a West Virginia mining company that U.S.
investor Wilbur Ross cobbled together from three bankrupt
firms. He also holds Joy Global Inc (JOYG.O: ), a manufacturer of
mining equipment, and Owens Illinois Inc (OI.N: ), which makes
glass containers.

Andersen reversed the model to short Pinnacle Entertainment
(PNK.N: ), a Las Vegas casino operator, and Ethan Allen Interiors
Inc (ETH.N: ), a home furniture company, whose debt-service
coverage – a measure of how many times it can pay its coupon –
has been decreasing. Shorting the latter earned nearly 30
percent since May.

The system is not bulletproof, however. Clothing retailer
Gap Inc (GPS.N: ) turned out badly for Andersen. In retrospect he
believes the company’s balance sheet was so healthy it could
throw money at ill-conceived projects. That may have been
picked up by a smart equity analyst more keyed into the firm’s
management.

Andersen says his strategy will yield results. When he
first sought out his old firm’s equity analyst in 2002, he was
stunned to learn no one knew his name.

“There is an interesting dynamic going on between the bond
people and the stock people – the analysts don’t talk to each
other,” he said. “If you’re an investor trying to get an edge
over everybody, you try to find relationships between seemingly
unrelated things and put them together.”
(Reporting by Edward Krudy; Editing by Kenneth Barry)

FUNDVIEW-Using bonds to find mispriced equities