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Manual Distress Investing: Principles and Technique (Wiley Finance)

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Robert H. Brethen Operations Management Institute. Sustainable Enterprise Partnership. Faculty By Name. Faculty by Discipline. Faculty Resources. Faculty Tools. Areas of Expertise. Behavioral Lab. Combine this with the fact that the discipline of distress investing doesn't always follow what conventional wisdom says, and you can see why it is one of the most challenging areas in finance.

Nobody understands this better than Martin Whitman--the legendary founder of Third Avenue Management LLC and a pioneer in the field of distressed markets--and leading academic Dr. Fernando Diz of Syracuse University. That's why they decided to write Distress Investing. As an outgrowth of annual distress and value investing seminars the two have taught together at Syracuse University's Martin J. Whitman School of Management, this reliable resource will help you gain a better understanding of the essential principles and techniques associated with distress investing and show you how to effectively apply them in the real world.

Divided into four comprehensive parts--the General Landscape of Distress Investing, Restructuring Troubled Issuers, the Investment Process, and Cases and Implications for Public Policy--this book comprehensively covers the practice of buy-and-hold investing in distressed credits, whether it be performing loans or the reinstated issues of a reorganized issuer.

From the recent changes to U. It burned more than 47, acres and engulfed homes. About 25, people were forced to evacuate. In an effort to curtail naturally occurring disasters, such as the Russian rubleinspired stock market meltdown or the equally vicious Nasdaq carnage of late , investment pros have tried numerous methods of protecting their clients against the occasionally vicious whims of market volatility. Much like the Forest Service, it remains questionable whether these attempts have resulted in any positive consequences.

Sadly, investment managers have been as unsuccessful in adding value during bull markets as they had during bear market periods. As a result, actively managed funds have become increasingly correlated to passive indices. What solutions are available to those truly committed to producing excellent risk-adjusted returns?

The purpose of this chapter is to describe the components necessary to build an actively managed fund capable of generating consistent, market-beating returns. A return in excess of a broad representation of the U. A return on par with the U. The previous requirements assume that the fund is considered in lieu of an investment in the stock market.

If the fund is to be used as a diversifier in a traditional portfolio, it must be non-correlated with the return of either A Dubious Track Record 3 the stock or bond market. The fund should also generate an absolute return that is large enough to keep from dragging down the performance of the overall portfolio. As we shall see, the requirements for building such a fund are vexing. Factors at the root of this difficulty include dealing with the issue of idea generation, the problems of asset size versus performance, and the question of determining which parts of the investment landscape are best suited for that most illusive of quarry—tradable market inefficiencies.

This exercise will lead us to a rather unconventional conclusion: Hedge funds and other alternative investments are better suited to generate exceptional returns than their more traditional mutual fund progenitors. Of course, this period coincided with the most spectacular bull market in history—a point not missed by proponents of active management. The year was the perfect year for evaluating the promise of active management to produce attractive returns during periods of declining stock prices and increased market volatility.

Instead of the broad market advances that made indexed funds the investment of choice in the last decade, proved to be a year in which a select handful of stocks performed spectacularly enough to take the market indices to new highs. So how did active managers fare? Still, investment managers seem to be obsessed with beating the market, even though they often end up defeating themselves in the process. As we shall see, the problem is more with the latter than with the former.

The most common method is the use of company fundamentals in discerning the fair value of a firm. This style of investing was inaugurated in , when the landmark text Security Analysis, by Benjamin Graham and David Dodd, was published. Like many great ideas, fundamental analysis is much easier to perform on paper than it is in the real world.

This is partly due to the large herd of investment professionals who use the method to manage billions of dollars in client assets. The resulting plethora of suspender-clad fund pros chasing the few incorrectly priced stocks that boast enough trading volume to buy and sell in large chunks makes a difficult game nearly impossible to win.

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Curiously, the group most enamored with fundamental analysis is its biggest customer. Institutional investors seem absolutely giddy about discussing various fundamentally-based methodologies with investment management candidates. Yet, it seems that this fundamental fetish shared by many big-time consumers of investment advice is a response to the bad reputation of the other school of investment philosophy: technical analysis. Market technicians believe that all of the information necessary to make a valid buy or sell decision is contained in the price of the security in ques- A Costly Conundrum 5 tion.

As a result, an examination of sales growth, profit margins, or other company-specific metrics is deemed to be unnecessary for predicting stock price movement. A cursory examination of price trends, trading volume, and other market indicators is all that is necessary, proponents of the approach argue. Even though security prices have an occasional tendency to move in trends, the financial witchcraft associated with technical analysis is anathema to the gatekeepers of pension assets and other sizable pools of money. Perhaps my investment manager is not keeping up with the market indices, these investors seem to be thinking, but at least they are not reading price charts.

Unfortunately, this evidence amounts to a molehill compared to the mountains of data that suggest the market-beating potential of human intervention in the capital markets—regardless of the approach used —is close to nil. When one examines just how good his or her forecasting ability must be, the difficulty in generating market-beating returns takes on a particularly astringent taste. Figure 1.

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On the flip side, one could make a large number of prescient but less accurate predictions. Note that the depth requirement dips dramatically as the number of useful insights approaches The curve only begins to flatten out as the number of good ideas passes A natural conclusion after examining Figure 1. After all, how can one generate such a large number of investable ideas without a cadre of highly trained professionals? Judging by the vast increase in hiring by securities firms, this line of thinking is hardly original.

The numbers become even more staggering for experienced players.

Some forward-thinking firms with the need to decrease their per-thought costs have sequestered at least part of their decision-making needs to computers. Quantitative models are excellent at sifting through mountains of economic and company-specific data, of course, but human intervention in the form of programmers is necessary to make this possible. As a result, computers have minimized —but not completely eliminated—the cost problems associated with generating the next great investing idea. Much has been written about the decreasing levy charged by brokerage firms in the past few years, which has served to vastly increase the vol- The Real Problem 7 ume of trading on domestic exchanges.

However, it is the other costs associated with buying and selling securities that is most troubling among market professionals. One of the most egregious is market impact, which is defined as the difference between the execution price and the posted price for a stock. Market impact can be substantial and is often quite large at the worst possible moment. In fact, the spread could widen so much that the manager may decide that, based solely on market impact, the trade is simply not economically feasible. Managers are thus forced to hold a position they do not want, which prevents them from using the cash gained from the transaction to buy a stock they do want to own.

According to Charles Ellis, author of the classic tome Investment Policy, active managers would have to be correct, on average, more than 80 percent of the time to make up for the implementation costs incurred in active trading. Unless market pros can get a grip on the onerous effects of such costs, the odds of generating market-beating returns appear quite slim. This one fact explains why so many investment managers are called to greatness.

The most effective solution—limiting the amount of client assets that they are willing to accept—seems an abomination to many. However, by directing a relatively modest-sized portfolio, there is no doubt that advisors are able to implement their market strategies in a more effective manner. Investment firms are barking up the right tree when they obsess about minimizing their transaction costs. If managers think that they have truly found a way to generate market-beating returns—be it through fundamental analysis, technical analysis, or a combination of the two—the trick is to maximize their fee revenue per unit of client assets under management.

This solution can take many forms. Some market pros may want to manage a much larger pool of client monies. In this view, managers assume that their revenue which would consist solely of an asset-based fee in this model is as dependent on their marketing acumen as it is on their breadth of market knowledge. Managers with a bit more ingenuity might decide to cap the amount of client assets they are willing to oversee. In return, they demand higher fees per dollar under advisement.

This usually takes the form of a performance fee, which enables managers to profit from the success of their trading activities. This latter course of action is commonly packaged in an unregulated pool of client assets referred to as a hedge fund. Such vehicles have the additional advantage of giving managers the freedom to express themselves in any way they deem most prudent in the capital markets.