Following Capital Structures Over Time to Extract Value: A Wall Street Transcript Interview with Michael Kao, CEO and Portfolio Manager at Akanthos Capital Management, LLC

Wall Street Transcript

67 WALL STREET, New York - June 10, 2014 - The Wall Street Transcript has just published its Investing Strategies Report. This special feature contains expert industry commentary through in-depth interviews with professional Money Managers. The full issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.

Topics covered: Secular Growth Themes - Small Cap Investing - All-Cap Investing - Bottom-Up Stock Selection - Quality of Business - Growth at a Reasonable Price - Long/Short Strategy - Investment Risk/Return

Companies include: General Motors Corporation (GM), Ford Motor Co. (F) and many others.

In the following excerpt from the Investing Strategies Report, a highly experienced portfolio manager discusses his methodology and top stock picks for investors:

TWST: Can you exemplify your strategy with a portfolio holding to help illustrate your process? I see that among your top holdings is General Motors. Do you still hold it?

Mr. Kao: In December we closed out our GM (GM) exposure, but that capped off a highly successful 10-year period where we traded GM under almost every possible guise. Ten years ago, when I first started Akanthos, we determined that GM presented an unusual convertible arbitrage opportunity as a result of its having issued three different tranches of convertible bonds. Because of their large size in the convertible market, the bonds were priced very inefficiently and consistently traded cheap, and so we viewed the best risk/reward in that capital structure at the time was to arbitrage the convertible bond against the stock.

Over the years General Motors became more indebted and the fundamentals declined. Now remember, this was the old GM, and the trades we did sort of migrated into where we were arbitraging the convert against straight debt, thus underscoring my theory of using the capital structure for maximum effectiveness.

TWST: Can you give a specific example of this arbitrage trade?

Mr. Kao: Sure. There was a point in time where you could buy the convertibles for, as I recall, a 14% yield, and you could short equivalent duration straight debt at a 12% yield. Typically a convertible ought to be priced at a premium to straight debt. And if all things being equal, if the coupons are the same, if the durations are the same, the convertible ought to be priced at a premium, because presumably there is some value that you pay for that underlying equity option. In this case the market was pricing the convertible 200 basis points wider than the equivalent duration straight debt. In other words, the market was paying you an extra 200 basis points to take the option, which was a complete inefficiency in the capital structure that we exploited.

Once the auto and financial crisis impacted Wall Street, GM became what I call a modern-day railroad bond. If you may recall from your history books, in World War II President Roosevelt commandeered the railroad system to ensure a reliable supply of war material. When he essentially nationalized the railroad system, their bonds collapsed down to five cents on the dollar. It wasn't fundamentals that drove the bonds to five cents on the dollar; it was a complete random active government interference that caused it.

A little-known trader by the name of Cy Lewis, at a then-unknown firm Bear Stearns, saw, based on liquidation analysis, these bonds could be worth par if at the end of the day we are a country based on the rule of contract law. Based on that assumption, he made what turned out to be an historic wager that paid off and put Bear Stearns on the map...

For more of this interview and many others visit the Wall Street Transcript - a unique service for investors and industry researchers - providing fresh commentary and insight through verbatim interviews with CEOs, portfolio managers and research analysts. This special issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.

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