The renewed strength that the US economy began to show late last year has translated into a number of opportunities in credit and equities domestically. On the credit side, our managers are tilting away from richer high yield and treasury bonds in favor of mortgage-backed securities and high quality corporate bonds. This reflects both opportunities in a battered-but-stabilizing mortgage market as well as a continued interest in safer credit given an uncertain global macro backdrop. A number of our managers have found an unlikely value in “distressed” subprime mortgages; much of what constitutes subprime these days is made up of relatively higher quality borrowers than just a few years ago in large part because so many bad credits have defaulted and fallen out of that cohort.
Nearly across the board, we are focusing on high-quality growth as a way to more safely capture equity market returns. This means attractive valuations, reasonable debt levels, positive cash flow, earnings stability and solid business economics (the gist here is tenacious companies with financial flexibility and strength at reasonable prices, which we believe translates in to a better margin of safety in down markets). Both in credit and equities, we are particularly watchful of the incredible stretch for yield that is occurring in the market. We are evaluating managers for the unintended risks that are being traded for higher yields as well as the substitutes that are being used for yield.
This is an excerpt from our article “Natural Selection” published March 13, 2012