Tech stocks have borne the brunt of the recent sell off in equity markets and with the Nasdaq firmly in bear market territory, it is unprofitable tech stocks that have been hit the hardest - down almost 60% this year.

But amid these sell offs, there can be category leaders that fall to attractive valuations, relative to their long-term growth profile. Seagate Technology (NASDAQ: STX) is an example of this today. It's a beneficiary on the ongoing trend around data moving to the cloud as our lives become increasingly connected, and it's priced at just 8x next year's earnings. 

In this episode, Alison Savas hosts a deep dive into the company.

Part one (2:20): Alison interviews Seagate Technology Executive Vice President and CFO, Gianluca Romano. 
Part two (22.00): Alison is joined by Graham Hay (Antipodes Portfolio Manager of Hardware, Industrials and Commodities) to discuss the Seagate investment case.

We thought we would review the cold, hard data on the financial year 2022 that came to an end on June 30. The data tables paint a clear picture: companies priced on high multiples coming into the year faced a sobering reassessment of their valuations, as did unprofitable businesses; the only safe haven was the energy/commodities complex; small stocks were shunned by nervous investors, and the tech sector was particularly under pressure.

The difference between high EV/EBITDA and low EV/EBITDA stocks in our "FIT" universe was the most stark - an 18% differential in price returns (where we split stocks into three baskets - low, middle and high).

Five of the worst six performed stocks were in the Buy Now Pay Later (BNPL) space, led by merger partners Sezzle (SZL) and Zip Co (Z1P) in first and third. The best returns came from an eclectic mix: heart device company Anteris (AVR) and  heavy equipment maintenance business Mader Group (MAD).

Some of the less obvious takeaways from our "FIT" universe were that:  it was not the case that the "dogs" of the prior year were the place to be - the "middle-of-the-road" stocks from FY21 held up best in FY22; and companies with market caps between $750m and $2 billion suffered notably worse declines than those capped under $100m.

The wash-up from FY22 is that we are now seeing more attractive valuations AND the recapitalisation opportunities we have been highlighting are beginning to flow. For bottom-up investors like Equitable Investors, we believe the opportunity set will be as rich as it has been in many years and we are keen to engage with investors who want to be part of this "recap" opportunity through Dragonfly Fund.

What is Convexity & Why Is It Important?

When credit instruments sell off, market participants will often talk about convexity being back. So, what is it?

Convexity can involve complex mathematics; however, a simple way to describe the concept is that it occurs where risk and reward are asymmetrical: positive convexity refers to an investment with more upside than downside; while negative convexity means the downside is greater than the upside.

During a risk-off environment, the price of a credit instrument typically drops below its nominal value (also referred to as "face" or "par" value) due to perceived increased default risk. As illustrated by the example in Chart 1 below, there is a compelling investment opportunity when a bond trades at a discount to its nominal value - assuming the bond does not default, a bond's price will benefit from a natural "pull" to the nominal value as it approaches maturity. This movement is referred to as "pull-to-par". Typically, bonds and loans that trade at a discount have positive convexity, offering investors enhanced yield and capital appreciation potential without taking excess risk.

Market Opportunity - Convexity & Higher Yields

Calendar year 2022 has presented significant turmoil for global financial markets amid a risk-off environment and sustained macro uncertainty. Global inflationary pressures continue to persist, including the ongoing war in Ukraine, slowing growth, higher energy prices and supply-chain disruptions. Central banks face substantial challenges as they look to combat elevated inflation with interest rate hikes, but without triggering a recession. Against the backdrop of wider spreads and the sell-off in rates over the past few months, fixed income yields have reset to higher levels, presenting an attractive opportunity for yield-focused investors. Global leveraged credit assets are providing a meaningful pickup in real yields when compared to traditional fixed income markets, as illustrated in Chart 2.

Higher yields and a decline in asset prices have introduced greater upside convexity in leveraged credit
markets for total return investors, particularly for high yield bonds. As illustrated in Chart 3, the proportion of the U.S. high yield market currently trading below par has climbed towards levels not seen since March 2020. Further, headline high yield prices have only been lower than their current levels for approximately 5% of the time over the past 10 years. With convexity in high yield bonds' favour, there's greater upside potential than downside risk as borrowing costs continue to rise.

This combination of higher yields and cheaper prices in an environment where bouts of volatility have become shorter and more frequent, is presenting alpha generating opportunities for active managers. History suggests investing in periods of dislocation, when yields reach current levels, provides attractive forward returns in the high yield bond and bank loan markets.

Market Outlook
Despite elevated volatility within financial markets this year, default rates remain below 1% and are tracking near historical lows. We do expect default rates to modestly increase moving forward given tighter monetary conditions and slowing growth. That said, even if we hit a recession in the next 12-24 months, we don't expect default rates to come close to the highs experienced in previous dislocations and anticipate they'll remain below historical averages. Expectations for a benign default outlook are supported by (1) healthy corporate balance sheets, (2) maturity walls that have been pushed out over the past year, and (3) leverage levels that are below historical averages.

Looking forward, we expect volatility to persist with the potential for asset coverage leakage and an uneven recovery across markets. We believe credit spreads are currently at levels that represent attractive entry points, but tail risks have increased, and we anticipate elevated credit dispersion as well as rising idiosyncratic credit events driven by a host of conflicting themes. We believe Ares is well positioned to provide superior credit selection and vigilant risk management in today's volatile market due to our disciplined investment process that focuses on capital preservation, predicated on bottom-up fundamental research with the goal of minimizing default risk by identifying and avoiding marginal quality credit. This core tenet of Ares' investment philosophy has resulted in significantly lower defaults in its bank loan and high yield bond strategies, particularly in periods of dislocation.

In summary, as investors are faced with rising rates and elevated inflation, many may struggle to determine how best to position their credit exposure in an effort to maximize yield and mitigate risk. At Ares, our differentiated approach to capitalizing on the best risk-adjusted return opportunities across the investable universe is rooted in the scale and integration of our Global Liquid and Alternative Credit strategies, which allows us to fully leverage extensive research and origination capabilities, proprietary technologies and longstanding relationships.

Written By Teiki Benveniste, Head of Ares Australia Management