Bonds Lead Stocks Out of Distress

Crushed by the Pandemic, This Company Takes Off

Watch This Stock Rise Like Its Bond Brother

Welcome to Porter & Co. Distressed Investing, edited by Wall Street’s Dean of High Yield, Martin Fridson.  To learn how distressed investments like this one help us take advantage of “The Greatest Legal Transfer of Wealth in History,” see the complete Guide to Distressed Investing on our Reports page. In addition to hosting Distressed Investing on our website, we also make it available as a downloadable PDF on the Issues & Updates page here.

Forgot your fedora? You’re fired.

Accountant Arthur Andersen was a stickler for propriety… honesty… and hats. He insisted that every one of his employees wear a formal chapeau on the job, summer or winter… or else. The requirements for correct behavior extended far beyond attire: they’d also get the boot if they mis-reported a meal on an expense form or added a point to their college GPA on their resume.

Most of all, Arthur insisted on absolute integrity in his accounting practices. In the 1930s – setting the tone for his business – he walked away from a lucrative DuPont contract when the chemical company pressured him to fudge numbers in its favor. Thanks to Arthur’s straight-laced guidance, his Chicago-based firm – founded in 1918, and named simply “Arthur Andersen,” because he’d proudly put his name on everything he did – grew into the world’s fifth-largest accounting firm by the 1980s, with 85,000 employees in 84 countries.

It was a good thing old Arthur died before his company picked up the Enron account.

At the height of the dot-com bubble, telecom companies – which were building hundreds of thousands of miles of physical cable bandwidth to support the growth of the Internet – seemed like a can’t-lose play. Cumulative investment in telecom infrastructure reached $500 billion in 1999 (over $900 billion in today’s money).  

Now helmed in the 1990s by ambitious, ethically ambiguous CEO George Shaheen, Arthur Andersen (the firm) marketed its services aggressively and became the go-to accountant for some of the biggest telecom companies – Worldcom, Global Crossing, and Enron, an energy giant that branched into internet services.  

The fedoras weren’t the problem. The trouble began when Arthur Andersen started wearing too many hats.

Seduced by multimillion-dollar consulting fees sometime in the mid-1990s, the accounting firm started acting not just as an auditor for its powerful telecom clients… but also as a friendly advisor. As it turned out, a little too friendly.

By 1999, Arthur Andersen had its own designated floor in Enron’s Houston, Texas, headquarters (populated by Andersen employees wearing Enron company polos), and regularly mingled with the telecom staff at company barbecues.

In between flipping burgers, Andersen accountants cooked the books. Former employees later reported that each client had two folders: one with “official” information for the records, and one throwaway folder that got destroyed at the end of the audit. As Enron’s humiliating 2001 U.S. Securities and Exchange Commission (“SEC”) investigation later revealed, “shredder trucks” were brought in and destroyed 7,000 pounds of paper an hour. 

There was plenty of evidence to shred. Starting in 1996, after Congress passed the landmark Telecommunications Act to deregulate the telecom industry, a glut of companies saturated the field (over 300 telecoms IPO’d in 1999 alone), network growth outpaced demand, and the deeply leveraged industry sank about $1 trillion (in 1990s dollars) into debt. The greed-fueled internet boom got ahead of itself – and was on shaky financial ground. 

But thanks to the telecom giants’ clever in-house accountants, no one would know that for a few years.

By the late 1990s – amid behind-the-scenes boardroom panic – many big telecoms were inflating their earnings by reporting transactions that didn’t really exist. 

The easiest way to do this was by selling each other IRUs – indefeasible rights of usage – which gave the buyer a permanent right to a certain part of another carrier’s fiber capacity. It was a daisy chain: many companies bought and sold IRUs on paper, or just traded them back and forth in a complex game of “network capacity swaps.” But little if any actual cash changed hands. 

However, big (fake) numbers routinely got recorded. Enron reported a net revenue increase of 28% to $40 billion in 1999, while Worldcom reported that it had nearly doubled revenue up to $33 billion that year. In actuality, those numbers were padded by billions. And for a while, no one was any the wiser.

No one except the junk bond market, that is…

High Yield Sounds The Alarm

By May 1999, the bubble was fully inflated. Amid that year’s insane telecom mergers-and-acquisitions (M&A) spree that totaled around $1 trillion in today’s money, the only cloud on the horizon was a failed merger talk between Nextel and Worldcom. 

History doesn’t record the source of the leak – but possibly it was someone wearing an Arthur Andersen fedora. As the accountant for Enron, Global Crossing, Worldcom, and others, Andersen had inside intel on almost every big telecom of the era. Could be, some of those “throwaway” folders weren’t really tossed… or “shredded” papers weren’t actually turned into confetti.

But in May, some savvy short seller or accounting watchdog noticed something wasn’t right and began to sell  – and the ICE BofA U.S. High Yield Telecommunications Index suddenly collapsed 4.1%. (In the same month, the telecommunications services component of the S&P 500 went up 1.9%.)  

Bond investors focus on solvency and are hyper-sensitive to anything that might affect that solvency. That’s because bond investors – unlike stock investors – aren’t concerned about growth potential; they just want to know whether they’re going to be paid back. And, in 1999, they seemed to be on to something, as evidenced by the selling that started in the bond market.

It took the stock market a while to catch on. The “network capacity” shell games continued for a few months… but, by the end of 2000, telecom stocks began to plummet. At the end of that year, as Global Crossing, Enron, Qwest, and other high-profile companies began to unravel under bankruptcy proceedings and fraud allegations, the S&P 500’s telecom services subindex dropped 35% from May 1999. (By that point, the ahead-of-the-game high yield telecom index had slid 21.5% from May 1999 levels.)

By 2001, $2 trillion in market capitalization had evaporated, half a million people lost their jobs, and the party was over in telecoms – ending with a spectacular post-crash series of SEC investigations and fraud lawsuits against the soon-to-be-bankrupt WorldCom, Enron, and several other companies.

Arthur Andersen went down, too. Found guilty off shredding documents and obstructing justice in the infamous 2001 Enron accounting scandal – and indicted in a host of cases along with other clients – Andersen lost its auditing license, along with most of its customers, and shuttered permanently. So much for “think straight, talk straight.”

In addition to a cautionary tale about crooked accounting, this story is a perfect example of how high-yield bonds are an advanced warning system…

It’s no fluke that the bond market caught on to the telecom crash well before telecom stocks did. High-yield bonds often predict the direction of their associated stocks (up or down) a few months in advance. We’ve taken advantage of the positive side of this phenomenon here in Distressed Investing with two bond recommendations followed by recommendations of the same companies’ shares: Diversified Healthcare Trust (Nasdaq: DHC) (up 14%) and Peloton Interactive (Nasdaq: PTON) (up 148%).

And in this issue, we’re doing the same thing.

In the cases of DHC and PTON, the bonds were offering very high yields when we recommended them. As their businesses improved, we later recommended buying their stocks – at prices that, in our judgment, reflected great upside potential.

We think of this process as topping up – as in getting a coffee refill at a diner. We’ll henceforth use this term to describe opportunities to buy the common stock of a company whose bonds we have previously recommended and liked. We will explore this notion more in depth this month.

The Stock Market Follows the Bond Market

In each issue of Distressed Investing, we are looking to find a distressed investment opportunity that’s underappreciated. Sometimes that process identifies bonds that trade at a substantial discount to their $1,000 face value. 

Finding such opportunities tends to be more frequent when markets – both bond and equity – are performing poorly. When markets are buoyant – as they have been recently – prices rise and discounts get smaller. That’s good news for the bonds we’ve already recommended, but it reduces our universe of attractive bonds to recommend. As bond prices rise, the potential return to new buyers goes down. 

When a company’s bonds are distressed and trade at big discounts, their low price means that if all goes as hoped – and the bonds increase in value when it becomes clear the company is able to repay them in full – investors earn stock-like returns. And the improving condition of the company means that the share price may also move higher.