Humans are drawn to simplicity. It's appealing when an investment has a good narrative that is easy to understand. The problem is they are likely to be appealing to other investors too, at this stage in the cycle, you're unlikely to find a stock or investment with a good narrative trading at a great price.
I recently spoke with Scott Nuttall, Co-President and Co-Chief Operating Officer of KKR, about how the global investment firm is investing the ~US$200 billion of capital that they manage. He articulated a compelling case for why KKR is focused on opportunities that require additional work to find acceptable returns for the risks they are taking.
Here are some of the key messages from the discussion with a link to the full video at the end of the article.
Image: Scott Nuttall, Co-President and Co-Chief Operating Officer, KKR
Buying complexity and selling simplicity
The popular narrative is that we are late in the cycle, with the US currently in the longest period of economic expansion in history. Scott says these broad observations about markets require you to talk to averages and take a '50,000-foot view'. Below the surface, he says things are more complicated.
"What we are seeing around the world is that if a story is simple and a security is liquid, it is extremely well bid, and it is very hard to get excited about investing. However, if there is some complexity to a story or there is illiquidity involved, we find that there is often excess return."
Nuttall says the financial crisis was a formative experience for the majority of people that are allocating capital today. The market continues to suffer from post-traumatic stress disorder, resulting in two patterns of behaviour that KKR sees opportunity in.
First, there is a tendency for investors to sell on the slightest sniff of bad news for fear of a repeat of the financial crisis. Second, KKR sees opportunity in the market's unease with illiquidity or perceived illiquidity.
Nuttall explains that the financial crisis was a liquidity-driven event which was unique and extreme. He says it may take a 'normal' downturn to reset peoples perceptions.
"Most recessions and most economic cycles do not have that element of liquidity drying up."
When he looks around the world today, Nuttall says there are not many asset classes suffering from a lack of liquidity. Yet KKR is also prepared to deploy money in the event of a downturn as they currently sit on US$50 billion in cash ready to invest.
"We're managing our balance sheet with a record level of cash. We are ready to invest when dislocation shows up, and we've seen these bouts in Q1 2016 and Q42018. But they tend to be very short-lived."
There's a lot of capital and liquidity in the world today. Scenarios can be made where a complex sequence of events result in liquidity drying up – but they are low probability scenarios.
His view is that most probabilities don't point to a liquidity-driven economic cycle.
Among KKR's focus are two distinct areas of opportunity. One involves uncovering opportunities arising from the concept of complexity, and the other is in private credit.
The market is motivating companies to be simple, and a big theme arising from this is divesting non-core assets. Public companies are on tight reporting schedules, and if they miss guidance or need to do a lot of explaining about an underperforming asset, then they get marked down by investors.
"We've been particularly busy all around the world buying non-core subsidiaries from corporates, both public and private."
He says the firm has been particularly active in Japan but believes this is a global phenomenon. A trend he expects to continue and says that a rise in activist investors is motivating boards and management to act and divest non-core assets.
The retreat of banks from lending markets in the post-financial crisis era continues to present new opportunities for private lenders.
"Even though we're ten years post the crisis, we still see very large opportunities in the private debt market. There are large parts of the middle market in the US and Europe that frankly, the banks are not lending to anymore."
Nuttall explains that as a firm, they get paid an "Illiquidity premium" in this part of the market and gains comfort from the fact that KKR can set appropriate levels of protection against their loans.
The final point that he makes is that they are on the lookout for bouts of emotional dislocation in markets and are poised to act quickly when these events occur.
Private vs Public market valuations
Nuttall says again that there is a temptation to talk in averages when looking at private and public market valuations. He highlights that earnings growth has come mostly from the tech sector; outside of that, there hasn't been much earnings growth.
He says there has been a bifurcation of the market, the 'haves' and the 'have nots'. Until recently there has been a cohort of companies, like in the tech sector, that can do no wrong. The 'have nots' can do no right, and the market has become increasingly harsh when penalising companies that fail to meet short-term earnings expectations.
"A fast-growing tech company is probably not where we are going to spend most of our time. We're spending time with the 'have nots', that are really liking the ability to be private and do the right thing for the very long term."
Nuttall says they regularly hear that it isn't much fun running a listed company. The aggregate number of listed companies is in decline, a trend that he expects to continue.
Three areas of caution
Without being overly 'bearish,' Nuttall highlighted three areas that KKR is keeping at arm's length.
He reiterated his view that the earnings growth experienced in technology over the past cycle is unlikely to be sustainable. Any exposure they do have will revolve around established technology that is a core service offering.
"We're not spending as much time in tech as we were at the beginning of the cycle."
Nuttall explains that the 'yearn for yield' has forced investors to accept additional risk to generate a bit more return. He says that there has been an explosion of BBB-rated corporate debt issued around the world and is an area they are actively avoiding. His concern is that an economic downturn or a 'hiccup' may result in this debt being downgraded. The result would be a 'significant fall' in the price of those debt securities.
The third area that KKR is monitoring is the ETF market and specifically those that offer access to leveraged loans and high-yield bonds. A mismatch exists between the underlying liquidity of the assets and the daily liquidity expected by the retail investors that have bought the ETFs.
"One of the things we're watching is if you see a significant amount of redemption from that loan and bond ETF world, there's a question about what happens with the underlying and how do you satisfy those redemptions."
Access the full discussion
The full discussion from Livewire Live 2019 can be viewed by clicking on the video below.
Thanks James. I particularly liked the point Nuttall made about the distaste the market has for complexity and illquidity, I've observed this as well recently.
Hi Tomas, I agree and it makes a lot of sense. I guess the issue for individuals is having the capacity / resources to conduct sufficient research that enables you to figure out the winners from the duds. Much easier done when you're running a firm like KKR. Glad you enjoyed it