Interview With Mark Okada Of Highland Capital

This piece contains the opinions of deep value investor Tim Melvin that do not reflect the opinions of Benzinga.com.

Deep value investor Tim Melvin had the chance to speak to Highland Capital Management Chief Investment Office Mark Okada ahead of the ENGAGE 2015 International Investment Education Symposium that took place at Wayne State University starting on March 26.

Below is a full transcript of their conversation ahead of that event.

Tim:    Okay.  We’re on today with Mark Okada, the Chief Investment Officer of Highland Capital.  Mark, thanks for taking some time to spend with us today.  I really appreciate it.

Mark Okada:    Thanks for having me, Tim.

Tim:    Now Highland Capital, those of us that are in and around the market all the time, are pretty familiar name, but to some of the folks reading this interview today might not be as familiar because you work on some fairly specialized areas.  Can you tell us a bit about your firm?

Mark Okada:    Sure.  So, our firm is about 21 years old.  We focus in the alternative space.  We have both institutional and retail products. We’re about twenty billion in assets under management and we’re also independent which always makes us a little unique in the space, but we’ve been at this for a long time.  We have a lot of scaling in what we do but really our focus since day one has been on, you know, alternative space and we’re located here in Dallas, Texas.  It’s our headquarters and really the main goal of our firm is to co-invest with our investors to provide really unique access products and also to add a lot of value to those accesses plus skills.  And so, you know, it’s a very competitive industry but alternatives are big growing part of the capital market and the investor interest, and we’ve being doing that for a long time, so we’re really excited about what’s going on with their firm and the future of our firm.

Tim:    I should probably thank you guys because you had some closed end funds back in 2009 and traded a huge discounts and I bought them and just did extremely well to say the least, so thanks guys.  Really appreciate it.  One of your expertise areas is really the high yield market.  That’s a market that’s on everybody’s tongue right now.  How do you guys see that market right now?  Is it still safe to wander in there?

Mark Okada:    Let’s define what we mean by high yield market.  There’s a high yield bond and high yield loans right, there is the loan investment grade credit universe.  Our primary activity in that space would be in the high yield loans or the leverage loan space.

Tim:    Okay.

Mark Okada:    We are one of the largest players and we’re certainly one of the oldest players in that business, we’re also very involved in high yield bonds too, so we have an active and long standing activity within the leverage finance space.  And so, from that stand point I can give you our perspective on what’s happening with both bonds and loans and I would tell you that the big focus I think from a lot of investors who look at the credit market through the high yield credit market, they tend to think about timing.  They want to know when to get in and when to get out of asset class: is this the  time I should herding in or out and certainly with high bonds that is, I don’t know, has been a smart payment to focus on.  It’s been the right way to manage exposures to that asset class and so, but Bank One has been on asset class for the past, its almost thirty years that I’ve being doing it, and I’ve only had one negative year. So it’s a different type of asset class in the way it’s managed and the value you have to had to pull a portfolio, and you just turn it over time. So to answer your question, first from the high yield bond standpoint and give you my perspective on what’s going on there, because I think from a timing standpoint, maybe the question is probably a little more relevant to the investor base that you’re talking to.  So, it is a very interesting time in high yield right now.  We like to market a bit more now than we did say, six months ago.  This moving energy has been amazing. The move in the commodity price and also with the other dynamic being that about the high yield index that you’re looking at, something like 15 percent of the high yield universe is related to energy in general, and that sector is under pressure, it will continue to be under pressure in our view for quite a while.  So, as energy goes, a big part of the high yield index will be moving, but with that being said, when we think about the overall US economy and the benefit that that economy is going to be getting from the price of oil being so much lower, there is really a very strong counter-punch to that move in energy bonds. 

So, we see the rest of the asset class doing fairly well and we’ve been playing a lot in both parts of it and getting very excited about the total returns. I think high yields could have a total return for the rest of the year, something between say, five or six percent from here which wouldn’t be a bad return number especially, you know, given what’s going on in the rest of the fixed income world when you think about bonds, investment grade binds, community bonds, and certainly margin market debt and CEFA bonds but their yearly yield, they’re very low, so that might not be a bad outlook but certainly oil is going to be a big driver of the performance there and the outcome.  So, I think it’s a little early to feel great about that projection but I will tell you as a stock pitcher, as somebody who has a firm that’s been doing this for twenty years, we’re finding a lot to do within the high yield bonds but much more to do in it now than say, six months ago. And so there are a lot of opportunities that didn’t exist say, six months ago but you’re going to have to be, you know, very careful about credit selection and make sure you understand what your borrowers are doing. So along with an answer about high yield, we are constructive but I think you have to really be careful with what you own and what you don’t own and be an active trainer in here so that’s my answer in high yield.

Tim:    Okay.  I have talked to some other high yield guys recently.  I used to dabble in this market back in 2003 and still have some friends in it, does the return of covenant life bonds bother you as much as it does some other folks?

Tim:    Well, we’ve seen it in bonds too.

Mark Okada:    Well, so bonds, bonds have never really had covenant, so there’s strength in investments that come and go but bonds have never really had cover per se but bank loans for a long time have, you know, very strong covenant packages and so that’s not the case for today.  There had been a lot of new issues that have been issued without covenants in the bank loans, but for some people, this is a concern.  To us, it’s just another one of the risk factors that we factor into when we think about you know how we are pricing risk. And so when I think about the bank loan asset class, I think we could make four or five percent as an index from here and so that would be a very nice return. Your floating rate, you’re seeing your secures, you are high in the capital structure, and so as a form of yield I think that the risk adjusted return within the bank of asset classes is actually better than high yield bonds. Even with the idea of having covenant life and so many other things that people are concerned with, but certainly the same dynamic applies to both high yield bonds and leveraged loans in that we are at the point of where dispersion and being a good stock taker per say is really going to be rewarded . It’s about the time where you are really picking the right credits, you are making sure that you understand what is in your portfolio, you are avoiding downside risks and making sure that you are on top of what’s going on. So I think the opportunities in loans especially are getting to be much more robust as a stock picker per say and the way we look at the market. We are adding a lot of value to what we are doing here on a trading bases and getting very excited about it.

So my stand point, I would tell you that I am in general much more constructive on what’s going in the credit crib market, that’s basically credit market than I was six months ago, and even when we talk about this energy situation, it’s very interesting what’s going on within the leverage loan space in the energy sector verses what’s going on in the bond space with the energy sector. So, if you were following what I said before, in the bond world its about 15 percent of the index is energy credit, in the loan index, it’s only about four or five percent. It’s a much smaller part of the index, but we are finding that the baby has been thrown out with the bath water for a lot of the loan credits, and so there’s then some really nice opportunity to step in and take down some of the loans that’s traded down significantly with the marketand add some nice fifteen to twenty percent of return potential and trade into our portfolios. But we really feel comfortable and very constructive about the downside even in a scenario where let’s say oil price is very low for a very long period of time, so there’s a very robust opportunity within energy credit within the bank loan space and we’ve being taking advantage of that and adding serious equity like returns to our portfolios in doing that.

Tim:    It seems like you might be one of the first one’s in here into the energy part of the bank loan markets because a lot of folks have very publicly said they are staying out of it for now.

Mark Okada:    Yeah, I think that’s a marketing move.

Tim:    Okay

Mark Okada:    Maybe, don’t quote me on that but I think it’s easy if your investors just say, “we don’t have any of it, so don’t worry about it”. And we are seeing some of that going on in the space and people just dumping exposure in general. And for us we love that because that’s an investor who’s selling for the wrong reasons. They are selling for marketing reasons. We want to be buying when people are selling for the wrong reasons. Yes, those prices are, look attracted to us. Now certainly we’ve to do our fundamental homework and understand the cash flows and the cloud covers for all of those deals but we do a very conservative fresh assumption on the names that we are putting in the portfolio. So I feel very good about the risk we are taking. It’s a bit of a constraint in-depth but we think, you know, I mean you’ve been around long enough to know that if you have that kind of debt and you deal with them well, it usually get paid off over a long run.

Tim:   Yeah, you are conferring in me would not be interested in the guy that’s not at least looking at oil at this point in time but you know when you are assessing a credit risk and as one stock figure to another, how do you control for this, that unknown variable of oil price moves? It’s just that it’s very difficult on this market place.

Mark Okada:    Fantastic question. So, there are credits within the space that are maybe mid-stream or tied in natural gas or have contractual cash flows that are not even tied to this value of the commodity for the next couple of years. So, we are finding situations where although, you know people are very concerned about the price of oil, I am not making a prediction of where oil is going to be in a year.

Tim:    Not even a little one?

Mark Okada:    No, well I would tell you that our assumptions are that it will stay lower for longer and we make those types of conservative outlooks when we are doing our own underwriting of these credits in general. And we want to pick situations where let’s say oil went to forty and stayed there for two years, now that’s not what would be a very draconian outlook and really hurt a lot of the oil and fuel service companies, it would be very difficult for some of the VMP companies when their engines blow off. But in that scenario, there would be companies like say, Exxon or some of these very, very large energy concern. They are doing these fields, these deep water fields, and they’ll be drawing them for the next fifteen years. I mean it’s not a one or two year sort of exercise, and they are putting billions of dollars into this development of these wells so, there’s not a scenario where you have to worry about them turning over the rigs anytime soon. And so there are very comfortable places for us to make some very good bets but we are not really exposed to the commodity price in any meaningful way, just because of this dynamic of you know everyone wanting to use their exposure, we are able to add very nice risk where we feel very comfortable with our downsize and we don’t have to make a big bet on the commodity price?.

Tim:   Ah, very good. Now you guys have pretty active distressed practice too, do you think a lot of the energy eventually ends up in that classification, and will attract your attention to the distressed side of things?

Mark Okada:   It’s depending on really three things. Number one is the commodity price and how long it stays well. In the high yield bond index, there’s about 30 to 60 percent of the issue have hedges in place that fully protect them from the downside of this move, so let’s say that’s you know, until at least around the end of this year. So there’s a lot of hedges in place. It’s not a situation where you are going to see a lot of defaults that are springing up because of that. The other thing is that there has been an enormous amount of liquidity that has been dedicated to this space for rescue financing from some of the private equity firms. So we’ve seen a couple of instances of that, like you know, main energy and so many situations where you know the private equity funds have a lot of capital and they’ve stepped in and they’ve given some rescue finance, secondary finance, and that will delay the day of reckoning for some of these company too. And then we’ve seen some issuance open up like energy twenty one or somebody that are credit sitter, they are borrowing money at the very highest rates and secures but they are doing that defensively to make sure they have enough liquidity in here, so it’s going to be depending on what happens with that, and so its far as whether their 408 spikes from here, is how much rescue finance is out there, how long the price stays low verses where the hedges are in place and then you know, what happens from here as far as where the capital markets are, as far as people having the ability to issue new bonds, to put off their issues. So we have seen three or four banks rises already, I think we will see more from a distractive stand point but this isn’t going to be the nastiest or bloodletting that I think some people are predicting. It’s just going to take some time to play out.

Tim:    And of course if T Boone Pickens turns out to be right, we’re seventy bucks this time next year then everybody is going to be pretty happy I guess

Mark Okada:   Ah certainly, it will be a great scenario.

Tim:   He was out with that call on CNBC this morning down slightly from his previous call of, was it ninety bucks in eighteen months?

Mark Okada:    My perspective on that is that it’s just not something that, you should enjoy it if you could. It must be very difficult to call it from here and for us with the capital that we manage and trying to being good stewards for our investors, it’s a pretty bold bet and so if you are on edge you are going to lose a lot of money for your client. If you are right you are going to make a lot of money, but I think a lot of investors are going into the alternative market to have a different type of exposure. They are not looking for someone who will be making these big swings, if they are doing that they’ll just to have an equity portfolio, alright?   

Tim:    Right.

Mark Okada:   They are looking to take risk away from their allocation and put it into things like long or short equity or credit where they have less correlation, less downside risk, more outfit generation and they are not exposed to something like a ten year treasury that could go from one and a half percent, to four percent or higher. They want to get away from that kind of risk, and so I think we have to be very careful with the type of bets we make and the way we put capital, I think we need to be very careful.

Tim:   You brought up something that raises an interesting question, are your funds just institutional in nature or can individuals use some of your alternative funds as well to diverse their portfolios?

Mark Okada:So, like I said, at first we’re like 20 billion, we’ve been doing alternative mutual funds for the last, about over ten years and we are about six billion in that space. 

Tim: Okay.  

Mark Okada:  We are one of the pioneers and leaders of bringing alternative to retail investors and we have three of the number one bonds in the space. So, it has been a very good experience for our investors, we really do take it seriously that as we grow our activity in the mutual fund space, we have to, you know, have good products, make sure we are disciplined about what we are providing for our investors and it shows nothing in having like a global allocation fund that is our number one in the space. The closing fund you mentioned, NHF is off for number one in the space, we have the number one long short equity fund in our long shot health care fund.

Tim:   Okay. You do have also in the firm a fairly robust oil and gas investment portfolio too. I saw it in your twitter feed actually, you guys just made a real big countering call on MLPs can you talk  about that?

Mark Okada:   Yeah, well I would refer you to what we said there but we do like that space. Again I think it also tight to what I said earlier, that there is a lot of me being surrounded by the past waters, that’s energy space. And MLP over the last couple of weeks has been one of them. I think they are cheap and you know we like that space a lot.

Tim:   I think there was a link to the comments in the twitter feed so I guess our folks can go there and find out exactly what was said by the variousanalysts in the report but it’s one of the few bullish calls I’ve heard on anything energy related in quite some time.

Mark Okada:   Well again I like what we are doing in energy credit and I am excited about it, I really am. We put together a whole portfolio of credits that we like and we are sorting them and I think we are going to make equity like returns in that and it’s a senior secured loan, it’s not unsecured bond by any way. So it’s great.

Tim:   You mentioned just a minute ago that you have the number one long shot equity fund in the health care long shot. Now, lots of folks are doing lots of things in healthcare but I haven’t really run across too many long shot healthcare portfolios because everybody is bullish in it. How are you guys differentiating what you do like and you don’t like in health care?

Mark Okada:  Ah it is. I mean, you want to talk about the perfect environment for a long shot fund in healthcare. We’ve got an entire industry that’s going through a massive sea change in the way all of the money flows through it. I mean you think about Obama care. You think about this need to pull in a lot more people into a system and yet figure out how to take costs out of that system. There are so many .winners and losers when you create this much change, so it’s perfect for a long shot. An example would be, if the hospitals are run systematically, possibly on the Obama care, we think they’ve gone a little bit over the scale, so we would go either short or underway there and then certainly if the supreme court challenge is successful you are going to see the hunch stock take a very hard downturn, right. But on the other side, there is a medical device tax that’s been put in place and that’s when we heard a lot of those companies and if we saw the Republicans get to momentum with the congress, maybe that task is repeal that would be very positive for those stocks. We are underway to a short bio tech in here so what we can get, it’s really risky. So there are certainly a lot of long short opportunities that are fundamental, that are driven by these secular changes in the industry and I really think that it’s really a perfect place to do long short healthcare. I suppose it’s just being more lonely.

Tim:    Okay.

Mark Okada:    We really like that.

Tim:   Yeah, that means you guys are one of the few firms that have had any discussion of short anything healthcare related because everybody is just wildly bullish and…

Mark Okada:    Take a look at our firm there I think you would like what you see.

Tim:   Yeah, I will be going through your holdings list at the end of this call because everybody I talk to is wildly bullish on it but here and overseas in Europe because of an aging population and that you know people tend to get myopic I think and they are just focusing on that one factor, and blame it on everything and healthcare. Now…

Mark Okada:    Yeah, it’s got a whole cross culture that’s based on just you know getting paid because our top client is growing. You got to look out because we ought to take care of our system you can’t just put this, you know, a growing population through the same system and then tend to think that you’ll be going to be able to afford it.

Tim:That’s the question nobody really wants to talk about so it’s how we are going to afford it all.

Mark Okada:    - but we have to.

Tim:    Now you have a regular long shot equity fund as well, any sectors that you like, dislike that you can talk about there?

Mark Okada:    I think what I would do with that one is, let’s hold that for Jonathan from the energy department and then we can follow up with a couple of talking points on that. It’s definitely for you, because you know he’s changing all the time and moving in and out of the different things.

Tim:    Right. Now I would have to set up another interview and can you talk with him then. Can you talk about your real estate practice at all, I mean because there’s a lot going on in real estate, lots of different markets and some interesting things going on. Can you talk about that at all?

Mark Okada:    I could but I am not going to. I am in the process of doing something. And so I am not really sure from a compliance stand point what I can talk and what I can’t, so I agree with you it’s a very interesting space. On the credit side, we are thinking about the home builders who are building products. I mean what a great benefit they are all seeing from the lower moving oil. I mean if you are a rug manufacture, I mean think about what your CFOjust told you and at the same time when the demand for your products are growing. I mean there’s some really good thing going on in building products and we’re playing a lot of that across the front too, so the real estate space there’s a lot to do there and we are very active in it, I can talk that something is going on, but I am not sure.

Tim: If we are not a hundred percent let’s avoid it because none of us want to have problems. So let’s see now, you described yourself on the website as kind of top down bottoms up which makes sense to me but so from top down, do you guys have a broader view of the economy right now?

Mark Okada:    Yeah, we see the US economy and it’s doing very well in general. If you think about the US economy and is split up between the corporate economy and the retail economy meaning, how companies are doing verses how the general population is doing. I think there’s a little bit of a divergence here. We’ve seen profit margins and revenues growth, productivity and an enormous research into all that versus corporate balance sheet in the US. I mean they’ve had cheap debt and an equity market that has been puff out by QE and really they needed all of that to grow their profitability and their top lines, to buy back stock, to do all sorts of accredited things to corporate health and its care. And over the last quota and we think of it as a couple of quotas, and we are seeing a softening of that. The strong dollar really impacts that a lot and certainly some of this energy fertility has being part of it. So we think that we’ve seen kind of the best from the corporate economy that we are going to see for a while because we are not going to call in for some sort of big downturn or recession per say, only if the US economy is still very good. On the other onside of the US economy for the general population we see that continuing to improve.  We think there will be a firming to hiring and  growth will be tied to that and so, I think the US economy from that standpoint is in very good shape. Corporate economy though is kind of platonic maybe we could see emanate kind of having issues from here.

Tim:   What would be a driver for corporations to switch from buy backs to cut backs, because honestly that has being one of my big concerns?

Mark Okada:   So I think we bought about anotherseven hundred billion of buybacks this year, which is crazy, since I mean, we don’t even have five thousand stocks, you know what I mean. It’s amazing to think about what has actually happened.

Tim:   It’s a significant percentage of the stock market gain over the past six years is buyback driven.

Mark Okada:    It’s huge, I call it financial engineering.

Tim:    So do I.

Mark Okada:    Whether it’s earning or buyback whichreally has created this enough forcompanies. Well, what is going on in the backdrop though is, there’s a huge deflationary trend that’s going on globally, when we have these currency wars going on with Japan, and now is starting with the Euro. The potentiality is that those currency wars with a strong dollar create deflationary forces within the US companies. Imagine if Toyota decide that they are going to compete on price which they haven’t so far, that’s why the profitability has been so huge but with the dollar yen move, it certainly would be easy for them to cut price. Same with the Germans, so that would be very deflationary and I think what companies would have to do in those sort of scenarios is respond with something to really help their margin situations not get worse. I don’t think its actually buying back stock. It’s investing cut backs, its also emanate though, I mean emanate would probably be the next big move. We would see I think a decent amount of emanate activity in the space, just to get bigger, it would have more pricing power. But cut backs really and how you use your cash and your balance sheet to create growth, true growth within your company. Here is what long term, to a point it’s the only thing that really drives shareholder value in any meaningful way, your buying back stock is fine, but you are just playing with the score board, you are just changing the matrix of what things are measured with, but in lecture you are investing real dollars in the real business that you are the steward of, you are not going to be driving long term profitability for your company, if your pattern supersede other people. So we see this buy back saving especially as valuation as they continue to move up…

Tim:    I have to tell you I have been appalled at some of the valuation I’ve seen shares bought back at. It’s been crazy.

Mark Okada:    it’s not a good use of capital from your point, and capec would be a much better use; and we are sorry to see these extremities. It’s like the airlines I mean they are at this point where they should be investing in their capital, I fly a lot and I can’t believe how bad the planes have been for Americans for all these years and men it’s so great when I get on a new plane.

Tim:   It is except they shrunk the seats on most of the newer planes and enough of them, when I fly by myself it’s all I am terrified by is a big person is going to sit next to me because there’s nowhere for me to go. Any industries that you think are susceptible really susceptible to emanate here. Where you know industry conditions almost demand it?

Mark Okada:    I don’t have anything on the top of my head to give you on that, so…

Tim:    What are the risks to all of this? What keeps you up at night?

Mark Okada:   You know you’ve got to keep an eye on the political risk, you’ve got to keep an eye on what’s going on in the emerging markets. In Russia, Ukraine, Brazil, Venezuela, China is recently coming back on my radar or something that could be concerned about a little bit but I am never comfortable. I get paid to worry so there’s a lot of stuff that we are always focused on. It is interesting that, I think there’s being a tepid in the US market, so good news is good news and bad news is bad news. But if you are in Europe or if you are in Asia, it’s weird, sometimes bad news is good news and good news is bad news, so these markets are kind of up and down. You get bad economic numbers and the markets go up because they think the druggy is going to respond with you know, just more of liquidity and more easing and that’s basically what happens. I mean the move for QE in Europe was driven by some very negative numbers on the inflationary form around energy frontand now the dart is at forty percent, you know, its very interesting. But the US market is a place where good news is good news and bad news is bad news and I think from that standpoint, if we are looking at the strength of the dollar, it is something that is not necessarily good news is if forty or forty five percent of the top-line of the S&P is international. That means you are really putting a meaningful head win on profitability for those companies.

Tim:    Just for a second, the European QE,do you think it works?

Mark Okada:    Well it depends on what it works for. If you are a German stock investor it’s already working, but if we are talking about the economy, like the basic economy, I have my doubts.

Tim:    Okay.

Mark Okada:   The European investor in general has much more fixed income than equity exposure. So when we talk about investor behavior and forcing people out of bonds and then to equities, Europe already had negative yields, or very low yield across the sphere anyways before this was announced. So, in that dynamic of capital rotation of coming out saving asset and the risky assets, it can happen and it surely has happen, but its not going to have the same effect as we’ve seen here in the US and certainly this is happening at different times, right. When the US is QE, we were in the heart of a lot of pain and this is way, way beyond the crises in Europe. So I’m actually of the mind-set that for the real economy, QE probably isn’t going to be that much beneficial. For the corporate economy it would be awesome. So it would be great for stock, I’m not sure it’s going to be great for the general population.

Tim:   Right, as we get ready to wrap up here, so I won’t take too much of your time this afternoon, you guys have a lot of experience in various alternative markets, any final thoughts that investors can use to not only make money but to keep their portfolios a little safer as we go through the rest of the year?

Mark Okada:    So, I think the big thing for 2015 and beyond is that you have to figure out what the signal is versus the noise, there’s a lot of noise, a ton of noise. I think the focus on the list office is often noise. Every time I pull up somebody’s blog or CNBC or something we are all talking about, you know whether it’s going to be June or September or wherever. The signal to me, the meaningful signal for US market will be end of QE. QE was a powerful force of dampening volatility, but also pushing up risk asset.  Equity markets erupt on average of about 15 - seven percent for that five year training period during QE, and volatility was declining and actually got cut in half to about eight percent in the final year. The end of QE is a massive signal and I think what it tells you and what you are supposed to think about from there is that we are going to see lower beta return involved in both the stock market and the bond market from here going forward and that we are also going to see more volatility and so far in 2015 that’s exactly what happened. This was my call at the end of the year last year when QE was going to an end. We are seeing it now, I think we continue seeing it for quite a while and so the punch line for investors in a scenario like that is that alternatives really have to become a larger allocationof what they are doing. And so it’s incumbent on all of us that are in the industry to help educate investors to understand, you know which alternatives they should be picking, how they should be allocated to them, and to understand how they work and what the returns should be. So I really think that the time is right for a very large growth in allocation to alternatives because I really don’t think that the traditional asset classes are going to provide the types of returns that investors have been used to and also are going to need much more volatile. So that’s my big message for 2015 and 16’ from investors. It’s a thing that we are going to continue to push on and I think it’s really important for our investors to be proactive and think about that with their asset allocation in here.