As a recession looms, defaults and bankruptcies are inevitably on the rise. However, the market is not paying enough attention to these risks.

A great example of this is Fitch’s projected high-yield bond default rate.

The agency’s projected rate ranges between 4% to 5% for the next year. Historically, it has required a financial crisis for high-yield default rates to reach the likes of 5%.

For instance, in the aftermath of the 2008 financial crisis, high-yield default rates were slightly above 5% in 2009, and in 2020 rates were 4%.

And yet, the market seems to be asleep at the wheel. We can look at how the market views credit risk by looking at credit default swap (“CDS”) spreads.

For high-yield credit, spreads are currently below 300 basis points (“bps”). Meaning that risky companies need to pay roughly 3% higher than today’s U.S. Treasury yield in order to refinance.

That’s not much higher than the spread’s average for the past five years… and it’s way lower than it was last year.

Normally during a recession, the high-yield spreads usually reach 700 to 1000 bps. We’re nowhere near those levels of fear today and as one of the experts in credit strategies, Fortress Investment Group, understands that well.

Fortress manages about $44 billion, mostly across the private equity and credit markets. The company used to be publicly traded until it was acquired by SoftBank.

It has a history of lending to companies on the brink of bankruptcy — often getting incredibly good deals because the borrowers are so desperate.

For instance, it has a history of lending to the media company Vice. Vice was once valued at $5.7 billion, and over the years, Fortress lent it about $280 million.

After Vice went bankrupt earlier this year, Fortress was quick to make good on its loans, and it acquired the business out of bankruptcy at a steep discount. Fortress isn’t one to shy away from taking on additional risks as it aims to take distressed companies and turn a profit from them.

Also, the fund is well aware of the current dispersions in the credit markets. To show its appetite for risk we’ve done a high-level portfolio audit of the fund’s top holdings based on their most recent 13-F.

Economic productivity is massively misunderstood on Wall Street. This is reflected by the 130+ distortions in the Generally Accepted Accounting Principles (GAAP) that make as-reported results poor representations of real economic productivity.

These distortions include the poor capitalization of R&D, the use of goodwill and intangibles to inflate a company’s asset base, a poor understanding of one-off expense line items, as well as flawed acquisition accounting.

It’s no surprise that once many of these distortions are accounted for, it becomes apparent which companies are in real robust profitability and which may not be as strong of an investment.

See for yourself below.

Looking at as-reported accounting numbers, investors would think that the Fortress Investment Group is just investing in below-cost-of-capital return companies.

On an as-reported basis, many of the companies in the fund are poor performers. The average as-reported ROA for the top 15 holdings of the fund is 3%, which is significantly below the U.S. corporate average.

However, once we make Uniform Accounting adjustments to accurately calculate the earning power, we can see that the average return in Fortress Investment Group’s top 15 holdings is actually 17%.

As the distortions from as-reported accounting are removed, we can see that KORE Group (KORE) isn’t an unprofitable business that’s losing money. In fact, its Uniform ROA is 38%.

Meanwhile, Kaleyra (KLR) seems like an unprofitable company as well, but this software company actually powers a 16% Uniform ROA.

That being said, we know that Fortress Investment Group’s actual specialization is in credit strategies and private equity.

That is why, it’s important to look at how the fund perceives credit risk and how they perform. Unfortunately, the distortion of as-reported metrics leads to misunderstandings and fades the actual credit risk of companies.

Using the companies among the fund’s top holdings that have a traded bond or a credit default swap (CDS), we can see the difference between companies’ actual intrinsic credit risk (iCDS) and the credit risk implied by their traded CDS or Spread to Worst (STW).

Take a look…

Using traded CDS or bond spreads (STW) as a proxy for balance sheet security, investors would think Fortress is just crazy and investing unsafe credits that will default in the next few years.

Many of these names have spreads that are much higher than their actual credit risk. The average spread is over 400bps. That’s higher than the average high-yield spread today.

In reality, though, the average company displays an intrinsic credit risk (iCDS) that is at roughly 120bps. This shows the intrinsic credit risk of these names is much lower than it appears looking at traded spreads.

Experts in credit strategies like Fortress Investment Group understand that well and while they may be looking like investing in a bunch of high-yield or near-default credits, they actually invest in safe, investment-grade quality names that offer high returns.

Once we make Uniform Accounting adjustments to accurately calculate earnings power and balance sheet strength, we can more accurately price the credit risk of companies Fortress invests in.

For instance, New Fortress Energy (NFE) isn’t a high-risk, possibly defaulting credit that warrants a 500bps+ yield on credit. Its iCDS is actually at 130bps.

Similarly, Marathon Digital Holdings (MARA) is also priced in for bankruptcy in the next few years as its traded credit risk warrants a spread of +2000bps. However, it actually is nearly investment-grade safe, with an iCDS at 120bps.

The list goes on for names Fortress invests in. If the firm just used traded credit spreads to evaluate credit risk, it’s unlikely they would be investing in half of these names.

Overall, we can see how Fortress is intelligent in taking advantage of the perceived risk of the market and the distortions caused by as-reported metrics.

From both the equity and the credit perspective the fund is highly concentrated on names that the market thinks will go bankrupt but the ones they know for a fact that they won’t. They are truly a master when it comes to distressed companies.

Yet, this is a highly risky strategy to follow and needs close attention to follow current valuations and traded spreads. That is why investors trying to attempt these types of strategies should carefully analyze the current valuations and spreads before jumping into an investment opportunity.

This just goes to show the importance of valuation in the investing process. Finding a company with strong profitability and growth is only half of the process. The other, just as important part, is attaching reasonable valuations to the companies and understanding which have upside which has not been fully priced into their current prices.

To see a list of companies that have great performance and stability also at attractive valuations, the Valens Conviction Long Idea List is the place to look. The conviction list is powered by the Valens database, which offers access to full Uniform Accounting metrics for thousands of companies.

Click here to get access.

Read on to see a detailed tearsheet of one of Fortress Investment Group’s largest holdings.

SUMMARY and New Fortress Energy Inc. Tearsheet

As one of Fortress Investment Group’s largest individual stock holdings, we’re highlighting New Fortress Energy Inc. (NFE:USA) tearsheet today.

As the Uniform Accounting tearsheet for New Fortress Energy Inc. highlights, its Uniform P/E trades at 6.8x, which is below the global corporate average of 18.4x, and its historical average of 17.1x.

Low P/Es require low EPS growth to sustain them. In the case of New Fortress Energy Inc., the company has recently shown 4% Uniform EPS growth.

Wall Street analysts provide stock and valuation recommendations that, in general, provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, New Fortress Energy Inc.’s Wall Street analyst-driven forecast is for EPS to grow by 106% and 24% in 2023 and 2024, respectively.

Furthermore, the company’s return on assets was 23% in 2022, which is 4x the long-run corporate averages. Also, cash flows and cash on hand consistently exceed its total obligations—including debt maturities and CAPEX maintenance. Moreover, its intrinsic credit risk is 130bps above the risk-free rate. Together, these signal low dividend risks and moderate credit risks.

Lastly, New Fortress Energy Inc.’s Uniform earnings growth is above peer averages, and below peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

This portfolio analysis highlights the same insights we share with our FA Alpha Members. To find out more, visit our website.