Before we get into this month’s individual deep value portfolio holdings, we need to look at the credit markets. Credit tells us whether investors are still willing to finance risk, and that matters enormously for small-cap deep value stocks.
Credit Is Calm, but the Weakest Borrowers Are Not
At the broad market level, credit conditions remain favorable. The high-yield option-adjusted spread finished the week at approximately 268 basis points. That remains well below our 350-basis-point caution threshold and nowhere close to the 600-basis-point level that would indicate a genuine credit crisis.
Investment-grade credit is equally calm. The AA spread is approximately 57 basis points, which remains close to historically tight levels. The Chicago Fed National Financial Conditions Index is negative 0.56. A negative reading means financial conditions are looser than average.
By those measures, we remain in Credit Nirvana. Capital is available, investors are willing to own corporate risk and the financial system is not flashing a broad warning.
There is, however, a rather large crack in the otherwise pleasant picture.
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The CCC and lower-rated high-yield spread is approximately 1,083 basis points. That is above our 1,000-basis-point warning level. The strongest companies have easy access to capital, while the weakest borrowers are being charged a much higher price. Wall Street can call that healthy differentiation if it wants. The companies paying those rates probably have a less cheerful description.
This divergence is especially important for small-cap deep value investors.
Small companies frequently depend on bank credit, revolving facilities, private lenders or periodic access to the capital markets. When credit spreads are tight, a business with a reasonable balance sheet can refinance debt, fund inventory and continue investing through a temporary downturn. That gives an undervalued company time for the investment thesis to work.
The same environment is much less forgiving for heavily leveraged companies with weak cash flow. The headline credit indexes may look calm, but the CCC market is telling us that lenders have stopped treating every borrower as if the Federal Reserve personally guaranteed the loan.
That is why balance-sheet strength remains one of the central requirements in this portfolio.
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