Sandy Rufenacht is a bond guy who figured out stocks.
The co-manager of the Aquila Three Peaks Opportunity Growth Fund says his high-yield-bond research leads him to companies whose stocks are primed to rise. “We find these ideas in advance of the equity market,” he says.
Mr. Rufenacht's approach is based on something he calls “return on debt pay-down.” The idea goes like this: Starting with companies that have high-yield bonds outstanding, identify the ones that plan to pay down debt and generate enough free cash flow to do so. Over time, as a company trims borrowing, debt-servicing costs decline, and more cash drops to the bottom line. Then, thanks to an improved credit profile, the company can get rid of restrictive covenants and refinance.
“With the new bond proceeds, they now do something that gets the equity market's attention,” Mr. Rufenacht says. “They buy stock back. They pay a dividend. They increase the dividend. Or they do an accretive acquisition with very cheap cost of financing — and the stock flies!”
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The $384 million Aquila Three Peaks fund, which Mr. Rufenacht oversees with co-manager Zach Miller, has grabbed on to some of those flying stocks, to judge by its track record. For the 12 months ended on Aug. 21, the fund's institutional share class gained 8.4%. That topped 97% of peer funds, according to data compiled by Bloomberg. For three years, the Aquila Three Peaks fund rose 22.1% annually on average, beating 99% of similar funds. For five years, the fund gained 19.4% annually, which was also better than 99% of peers.
BOND ROOTS
A native of Imperial, Neb., Mr. Rufenacht has bond roots that go back two decades. He managed the Janus High-Yield Fund from its launch in 1995 to 2003, when he left Janus Capital Group to start Three Peaks Capital Management. The Castle Rock, Colo.–based firm now oversees about $750 million in assets. In 2006, Mr. Rufenacht started a high-yield mutual fund for Aquila Group of Funds, a New York–based municipal bond shop. He'd been managing stocks for clients in separate accounts at Three Peaks. So in October 2010, he took the reins at Aquila's equity fund, changing its strategy.
Mr. Rufenacht says his equity strategy comes out of the conservative approach to high yield he developed at Janus. Its main aim, he says, is to avoid defaults. “I wanted to use the asset class but weed my way through it,” he says.
To do that, Mr. Rufenacht focuses on four things. First, he buys only true high-yield bonds, not other securities such as convertibles that junk-bond investors sometimes buy. Second, he avoids companies in cyclical industries that tend to end up with too much debt when the economy turns down. “I instead try to find anti-recessionary types of industries like the supermarkets, cable, health care — even the casino industry historically,” he says. Third, he aims for shorter duration than the benchmark to reduce risk from rising rates. Fourth, he seeks companies that have articulated a desire to pay down debt — or have the ability to do so. “What I'm really looking for is that they've got this free cash flow,” Mr. Rufenacht says. “Debt doesn't merely stay flat, but it actually goes down because they take the checkbook out and they pay off bank debt.”
LEVERAGE TO PROPEL SHAREHOLDERS
Mr. Rufenacht says that the approach enables him to find companies with “the perfect balance sheet.” Such firms “have enough leverage to propel shareholders' equity, but not so much leverage that they're looked down on in the high-yield market.”
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Consider Sealed Air, for example. Back in 2011, the maker of Bubble Wrap packaging bought Diversey Holdings, a maker of cleaning products, in a $4.3 billion deal. Before the acquisition, Sealed Air had about $2 billion in bonds and loans. Afterward, its total debt jumped to $5.9 billion.
The next year, the company announced that cutting debt was one of its main goals. “Sealed Air even linked a significant portion of CEO compensation to achieving its debt-reduction goals,” Mr. Rufenacht says. In mid-2012, when the fund first bought Sealed Air shares, the stock traded at about $15.
One of the bonds that Sealed Air sold in 2011 to finance the Diversey acquisition was a $750 million issue of 8.375% senior notes due in 2021. It was the company's most restrictive bond, Mr. Miller says. Among its covenants was a so-called limitation on restricted payments. Commonly called an RP basket, the covenant constrained the pot of money that Sealed Air could use to pay dividends or buy back stock.
In 2014, the company offered to pay a consent fee to loosen the covenant, but bondholders rejected the proposal. “We knew that the writing was on the wall that Sealed Air was committed to executing a large share repurchase program,” Mr. Miller says. So the fund bought more shares, he says. This June, the company got rid of the bond in a mandatory tender offer. In July, Sealed Air, whose market value was $11 billion, announced that it would buy back up to $1.5 billion of its stock. Shares traded at $52.17 on Aug. 21, having risen about 50% a year since the fund first bought them.
Mr. Rufenacht says that at its root, the strategy draws on a simple premise. “I'm from a small town in Nebraska,” he says. “When you borrow money, you pay it back.” That's always a good thing, he says.
