Lead-Lag Live

Jay Hatfield on Small-Cap Stocks, Tariff Impacts, and Strategic Investment Success

• Michael A. Gayed, CFA

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Unlock the secrets of informed investing and sidestep the pitfalls of market gambling with insights from Jay Hatfield of Infrastructure Capital Advisors. Explore the nuanced interplay between tariffs, political narratives, and inflation expectations, as revealed by a University of Michigan survey. Jay shares his 35-year Wall Street journey, highlighting the stark differences between hedge fund analytical frameworks and traditional investment analysis, all while emphasizing the critical importance of informed decision-making in building successful investment strategies.

Venture into the dynamic world of small-cap stock investments, where political maneuvers like tax cuts and interest rate adjustments can dramatically reshape company profitability. Discover the disciplined approach of the SCAP ETF, known for its focus on profitable and dividend-paying stocks, and learn how rigorous analysis and a well-curated portfolio are pivotal in capturing market opportunities. We also shed light on the structure of investment teams and the strategic allocation within the Russell 2000, underscoring the importance of experience and analytical rigor in achieving investment success.

Navigate the intricacies of writing calls for alpha in the aerospace sector, and understand how small-cap stocks can offer unexpected market surprises compared to their large-cap counterparts. Explore the strategic potential of short-term call writing on large-cap stocks and how institutions are capitalizing on market behaviors influenced by less experienced traders. Finally, turn your focus to the bond market, where active management and sector diversity reveal opportunities amidst fluctuating interest rates. Experience the challenges and triumphs of balancing equities and bonds to pursue solid returns through informed, strategic investing.


DISCLAIMER – PLEASE READ: This is a sponsored episode for which Lead-Lag Publishing, LLC has been paid a fee. Lead-Lag Publishing, LLC does not guarantee the accuracy or completeness of the information provided in the episode or make any representation as to its quality. All statements and expressions provided in this episode are the sole opinion of Infrastructure Capital Advisors and Lead-Lag Publishing, LLC expressly disclaims any responsibility for action taken in connection with the information provided in the discussion. The content in this program is for informational purposes only. You should not construe any information or other material as investment, financial, tax, or other advice. The views expressed by the participants are solely their own. A participant may have taken or recommended any investment position discussed, but may close such position or alter its recommendation at any time without notice. Nothing contained in this program constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in any jurisdiction. Please consult your own investment or financial advisor for advice related to all investment decisions.

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Speaker 1:

People totally misunderstand tariffs, partly because of just the election and political talking points. So, for instance, umich came out a survey of individuals and the expectations for inflation went from three to four percent. Okay, but for Democrats it was five and for Republicans it was zero. So obviously talking points are pretty effective, like the Democrats actually convinced themselves that Joe Biden was their best candidate because he's sharp as a tack. You've got to be careful with talking points, because you can really talk yourself into it.

Speaker 2:

I am looking forward to this conversation with Julia Hatfield, who I'm going to break bread with next week in Vegas at the Money Show, when he and I are going to be both presenting there in Vegas at the Money Show and he and I are going to be both presenting there. This will be a good conversation around not just markets and macro, but also I want to get into the weeds around. How do you actually build an investment process with a bunch of very smart people, and I think that part of this industry is often underappreciated by, ultimately, end investors. How do you actually come together with a team of smart people to come up with a portfolio? So, with all that said, my name is Michael Guyatt, publisher of the Lead Lagrime.

Speaker 2:

Before we join me here, jay Hadfield of Infrastructure Capital Advisors. They are a client of mine. This is a sponsor conversation. We're going to do a number of these types of interviews in the months ahead. But, jay, I know we know each other, but there's some people that still are not familiar with your background. So, as always, introduce yourself. What have you done throughout your career? What are you doing now?

Speaker 1:

Great Thanks, michael. So I've been on Wall Street for 35 years. I have an MBA from Wharton, cpa, ernst Young and about. At the time I was an investment banker doing utilities and MLPs and the rest of the time on the buy side. I worked for two large hedge funds and that's really where we got our analytical frameworks from that we can discuss in detail. And then launched my own firm, started with a hedge fund, then actually launched an MLP. It's public-retreated NGO energy partners. My friend Mike runs that out of Tulsa. And then we launched our first ETF, amza, in 2014. Pffr is 17. Pffa our flagship preferred stock fund 18. And then ICAP, scap and bnds. Over the last three years you mentioned the hedge fund analytical framework.

Speaker 2:

What? What's different about the way hedge funds analyze investment opportunities versus traditional buy side or sell side?

Speaker 1:

well, the we think we have sort of the best of both worlds, because when you're running a true long short fund which I don't recommend but you're have to be almost 100 correct because you're long coke and short pepsi, so you have to have a much more detailed model to try to ferret out, and you know it's harder with regulation and FT these small differences in growth prospects, valuation, catalysts and opportunities, so that now what I don't like about that is you always lose money on your shorts and you make money on the longs because companies are retaining earnings, growing earnings and going higher retaining earnings, growing earnings and going higher.

Speaker 1:

So all you're really doing is just reducing the return on Coke by being short Pepsi. So we don't do shorts, but we will pick Coke over Pepsi because our models show there's more upside to consensus that it's undervalued relative to growth. So that's probably the core that I'd recommend, to the extent that your listeners do their own work is you adopt our we call it peg-y ratio. So you want to buy a profitable company, so never buy an unprofitable company. The trade of reasonable multiples of growth, so their PE relative to growth is reasonable. But we mostly have yield security, so you do have to correct for yield. So it's great that, say, nvidia is growing at 20% a year and it's not so great that Southern Company only grows at 5%. But Southern Company has a 5% yield, so you have to correct for that. So it really has a total return of 10 versus NVIDIA total return of 20. So that's the multiples you should focus on.

Speaker 1:

So by doing that, what you do is avoid blowups. Like Palantir is a great momentum stock, but you really can't get to the current valuation and that'll be fine until it's not. Or a better example would be Tesla. Everybody loves it because of not so much recently, but because of Trump being elected. But if you look at the multiple growth to the amount of growth relative to P ratio, it's terrible. It's just a really unattractive investment. So not that you shouldn't be in Tesla, but you're gambling when you are. So we try to take the gambling out of it and you stock the odds in your favor. You avoid blowups and you can get a lot of upside because of the companies deliver and the growth translates. Then people revalue it closer to a market peg ratio. So we think it's a great way.

Speaker 1:

It takes a lot of work, so it's not bad to outsource to people like us. We talk to the companies, which is hard for individuals to do. We run our own models, but that's really what you need to do. And also I would avoid people who make recommendations about stocks who don't do that. You know we could pick on some public figures that do that Like you shouldn't have opinions about. You know, 500 stocks in the S&P 500. You know, 500 stocks in the S and P 500. Like, if you're not running your own model, talk to the company. Then those, those opinions are just as good as throwing a dart at the newspaper David.

Speaker 2:

Pérez Obviously I like the philosophy of take the gambling out of it. Uh, I gotta imagine it's a bit frustrating in this cycle because it seems like the perception out there that it is gambling that is a casino. I mean, look at all these lever products, look at the way some of these companies, which, to your point, have no earnings, are just going ballistic and everyone's chasing and beating their chest on how much money they're making. There are cycles to these things, but has this been a particularly annoying one for you there?

Speaker 1:

are cycles to these things, but has this been a particularly annoying one for you? Well, I think that where that really showed up was in 21, because that was insane. And people say, oh well, I'm worried about bubble. Now I'm like, look, the one time you should be worried about a bubble was when the Fed is jacking liquidity. And they were jacking it like it's never happened before. They increased the money supply 75% Not even anything close to that's ever happened and they didn't care.

Speaker 1:

Which is even more ridiculous, and that's what was driving the Bitcoin meme stocks just way too much liquidity coming into the market. That wasn't really frustrating as much. We're happy to do like in our hedge fund we did 70. So we were happy to do that. But our other funds were all a lot because every money was flowing into all asset classes, so we don't mind that. I think you should keep your eye on it because it's a sign of a bubble. But right now, even if, like DJT or Tesla, starts running because the election, you see it quickly that energy come out of the market because the Fed's not jacking liquidity. In fact, the Fed is restricting liquidity still. So we haven't even seen the beginning of a real bull market yet.

Speaker 2:

Okay, that's an interesting statement. I want to go back to that in a second. But Fed jacking liquidity, what about Treasury jacking liquidity? I mean the Fed raised rates At the same time. The Treasury, you'd argue, was playing games on the yield curve as far as the issuances go, putting liquidity a different way.

Speaker 1:

You know we have a totally contrarian view on that. You know everybody likes to get on all these TV shows we go on to, but I'd say like, oh, the term flamie and this and that. But. And of course, the Fed chair today, who I don't think is really a good economist, he's a good politician was saying well, we do not control the long end of the curve. Ok, you don't control the long end of the curve, but you absolutely can move it to wherever you want by short rates. And if they couldn't, by the way, the monetary policy would never work. So, in other words, the Fed tightens short rates, drives the long end up and we have a recession because housing breaks that's happened 11 out of 12 times since World War II.

Speaker 1:

Fed causes all recessions. So if you look back to before it became obvious Trump was going to be president, the 10-year was like 100 base points lower than it is now, and the terminal rate on the Fed funds was estimated to be surprising 100 basis points below where it is now. So the notion that they're disconnected is not true and you just abuse 100 basis points as a rule of thumb. So we think the terminal rate for the Fed is actually 3%, maybe two or three quarters. So you add a hundred that gets you three and a quarter. So we are bullish on rates. Because the fed doesn't know that inflation is coming down, they're going to cut three more times, going to drive the tenure down is that part of the reason why you're saying the real bull market hasn't started?

Speaker 1:

There's another esoteric dynamic which hopefully your viewers have some time for. But we track the global monetary base. So our monetary base is shrinking by 3% a year, which is deflationary. But you would think the rest of the world would be growing right, because they're cutting rates. Well, the dynamic is, rates were so high that, even cutting them to where they are now, all monetary policy throughout the world is still restrictive, even though our Fed doesn't really fully understand that.

Speaker 1:

So that's the best way to go to like if you were assessing monetary policy in 21, you would be freaking out, okay, because, like I said, the Fed increased the money supply 75%, so they're going to have to reverse that. You can't do that. You're going to have inflation. Now they have to cut rates. You can't keep shrinking the money supply or else you're going to have a recession. But that's happening globally. So, as the rest of the world is going to be ahead of us, they keep cutting. They'll actually finally start adding liquidity instead of subtracting it. I can get that on our website, only on our website Global Money Supply. If you follow the Global Money Supply, you will always make money. You could have seen it ramping up into 21. You could have printed money. Hopefully you would have gotten nervous that it's just too high. So, remarkably, 95% of market participants don't care about the money supply, but it's the most important thing to look at.

Speaker 2:

So where my mind goes to in hearing, that is what happens with tariffs, right? I mean, if tariffs are going to be a form of cost push inflation, how can the Fed really cut rates aggressively?

Speaker 1:

barring some kind of calamity in equity markets. Well, we think that people totally misunderstand tariffs, partly because of just the election and political talking points. So, for instance, umich came out a survey of individuals and the expectations for inflation went from 3% to 4%. Okay, but for Democrats it was 5% and for Republicans it was 0%. So obviously talking points are pretty effective. Like the Democrats actually convinced themselves that Joe Biden was their best candidate because he's sharp as a tack, they've got to be careful with talking points effective, like the Democrats actually convinced themselves that Joe Biden was their best candidate because he's sharp as a tack. They got to be careful with talking points because you can really talk yourself into it.

Speaker 1:

But the thing about terrorists is that when forget the talking points, when properly analyzed, you have to think of them as a sales tax. That's a one-time increase in the price level Even Neil Kaskari has said that should be looked through by the Fed and then in the long run, you're taxing consumption so you have less demand, you're paying down government debt and then that's going to get invested. So the two things. And then the other thing is that nobody looks at the dollar. The dollar's appreciated 8% since Trump got elected. That's massively deflationary. So why do all the political pundits and they're political pundits, not economic care about tariffs, but they don't care about the fact the dollar appreciated 8%. That keeps oil prices low. That keeps other commodities low, puts a restraint on import prices. That keeps other commodities low, puts a restraint on import prices.

Speaker 1:

So I'm not saying that it's fantastic for inflation to raise tariffs, but it's just not material. Inflation is caused by excessive monetary growth, not tariffs, not immigration. It's basically immaterial. But the real thing to focus on, all the nonsense or confusion coming out of Washington right now is basically irrelevant until we get that tax bill and that's going to say if we have a corporate tax cut or not, and that affects our price target on the S&P by 1,000 points. So if we go to 15% full out, which probably won't happen 7,500, no corporate tax, 6,500. So look at that and the tariffs will pay for a big part of that tax cut. So, strangely, tariffs are good for the stock market Not every stock, obviously because it pays for tax cuts to go to corporations.

Speaker 2:

And presumably the biggest beneficiary of that would be on the SMIT side right. I mean the tax benefits would much more likely benefit some more companies than large cap, mega cap.

Speaker 1:

Absolutely, and that's why you have to be careful. Like we're using 18, so we have a 7,000 target because they can save 15. But really it's like, oh, you have to be a domestic manufacturer and you have to do this and that Now there's going to be other corporate tax breaks, like expensing R&D, probably expensing capital equipment. So that's why we just use 18% effective, so it doesn't have to actually go to 18. But if you get a whole panoply of corporate tax cuts, earnings estimates go up in 26, and that's what drives our multiple. So that's where the rubber hits the road. So we're just counseling people Don't get caught up in the politics. There's a lot of things. Well, more than 50% of investors did not vote for Trump. They're trying to come up with reasons why it's going to blow up, and that's okay. I don't care, just trying to make money. I care about the tax bill. Forget tariffs, forget immigration. What's going to be in that tax bill? How's it going to get paid for? Are they going to cut expenses? That's what matters.

Speaker 2:

You said earlier, never buy an unprofitable company. Presumably, with tax cuts there are going to be a bunch of small cap unprofitable companies that suddenly become maybe profitable because on top of the tax cuts which they've got profits that you're going to have more demand being stimulated for products and if the Fed's going to lower rates or if rates are going to drop in general, that should take away some of the refinancing risk. So from a process perspective, how long do you need to see a prior unprofitable company become profitable to consider it, for example, in S-Cap?

Speaker 1:

Well, we do. We do forecast. So if we thought it was going to rapidly become profitable next year, then that would be fine. It's more companies that are I mean the ones that are easy to avoid in SCAP and where you will blow up is biotech companies that are very digital. You know, either it's the drug gets approved or it doesn't, and I always get my guys to try to keep track of all the Russell 2000 biotech companies that literally go down like 90% in a day. So it's more. Those type of companies will become profitable if their drug gets approved and will get wiped out if they don't. So we want digital outcomes. If it's just they're growing revenue getting to profitability and it's going to turn profitable next year, then we would consider it is a little bit riskier. But that's basically what we used to do as investment bankers at Morgan Stanley Just had to be profitable for one quarter before we'd take it public.

Speaker 2:

Let's talk a little bit about SCAP. Talk to me about the process behind that ETF and, first of all, why even come out with this? As is the case in the ETF world in general, a lot of funds out there are tracking a lot of different parts of the marketplace. A lot of them do largely the same thing, just variations of beta. What makes S-Cap different?

Speaker 1:

Well, we like to offer investors substantial income when they're making investments. It's very difficult to get good yields out of small cap stocks, so we thought we could add value by first curating the universe to have all profitable and dividend paying stocks, cause that's a big quality uptick is that dividends. And then we do carry a small amount of preferred stocks, which enhances dividend, and we have a very particular way of writing index calls that adds more alpha and income. So I would challenge you to find any other fund yield I think it's almost six anywhere close to ASCAP. And I do look at it. By doing those things, those features, we've actually made it less volatile than IWM or Russell 2000,. And you should look on the website to get the exact details. But you see that it's been more, way more.

Speaker 2:

it's outperformed the Russell substantially how many positions are in the portfolio typically?

Speaker 1:

We are a pretty well-diverse site so we have about 70 positions. We're constantly. We don't just like do the analysis stick in the portfolio as the stocks are moving up and down. They're relative. We do relative multiples. So if a stock has a huge run like we own C-O-K-E, which is a bottling company, everybody hated it. They did a share purchase that went up 45%. Well, now we don't own it anymore because it doesn't screen as reasonable PEGI ratio. So we're constantly monitoring trimming as stocks run, buying, potentially buying more as they come down or they have to be all cooked up with that. So we have a constant monitoring system that tracks relative multiples within the sector and then we adjust it slowly. We're not big traders but we all take profits. It's a good way to limit risk. Got 3% position that runs up 40%. Now it's at 4.2%, so it's fine to trim it.

Speaker 2:

You keep saying we so talk me through the investment team. How do you even put together a committee when it comes to figuring out how to even do research? I mean, I think a lot of people don't understand that it's not easy to get a lot of people together in a room talking about investment ideas and then figuring out on top of that which ideas should go in, which should go out, what should be primmed, what should be added.

Speaker 1:

Yeah, so I'm CEO and CIO, but I'm really kind of 95% CIO, so I do things like have these calls. We don't have any staff meetings to talk about staff issues. We talk about stocks all day long and then we have four analysts that are all in the same room, so they're constantly and the head of research is in that room too.

Speaker 1:

So they're constantly running models, analyzing, talking to the companies, updating their models, updating their targets, recommending buys and sells. And then it does help to have somebody who's just kind of made all the mistakes you can make. You know, if you've been on Wall Street 35 years, you've kind of seen every blow up to kind of make the final judgment about like oh yeah, those type of companies they usually blow up or yeah, that's a good company, kind of the final arbiter. But there's an investment process that goes through the analysts up to the head of research and then I approve the final recommendations.

Speaker 2:

I'm looking at the holdings. It's interesting to me that you got 10% roughly in the Russell 2000 small caps, which to me correct me if I'm wrong it seems like that's one of those things where maybe there aren't enough interesting opportunities and you still obviously have to be within a risk parameter for individual positions, so that becomes sort of your bucket.

Speaker 1:

Well, you know, this snapshot's a little bit higher than we normally. Keep that like three to five percent. But the reason for that is I didn't get into all the details. But we don't like some call writing funds.

Speaker 2:

Ah, okay.

Speaker 1:

Yeah, because they write too many calls, yep. So they'll just like and they're not covered by anything. Okay, so like a Jeppy has a structured note and if the SMP runs, they just lose their you know what on that structured note. They just lose their you-know-what on that structured note. But what we do is we write a much smaller amount on IWM so that if it goes into the money, we just deliver IWM shares so we don't take a loss.

Speaker 1:

And we've got to learn this. You know writing AMCA, you know writing naked calls just makes people really nervous, as it should. So we like to have Delta stock to offset that and we're constantly monitoring. So we never want to have an investor call us and say, well, why did you underperform the index? Because you know small dApps are really ripping. You know a JetPay will say, oh well, because we wrote all these structured notes and we'll say, well, you know, we had some IWM called away, but then we bought more, then we bought back some calls, then we added other. So it's something that we are. It makes people nervous, so we keep it to like three to five. Normally, like I said, this snapshot we might have just had a little bit extra than we normally do.

Speaker 2:

Well, I don't know if you've calculated this, but what percentage of the yield comes from the options side?

Speaker 1:

It's like about one and a half percent, so like we're about like three quarters covered, we are raising that dividend. So that's you know from where for keeping raise it. But it also just adds alpha, which is important too. I don't think we've ever I mean the market thing kind of blotted us simply lots of fun, but it's been almost 100% profitable.

Speaker 2:

Yep. Talk to me about some of these other positions here, like Casey's General Stores, Herc Woodward A lot of people may not be familiar with these names to begin with, so what's compelling about some of these companies in the top holdings?

Speaker 1:

Well, they all have the same thing in common, which is they've got great balance sheets. Like kind of the notion that small caps underperform when interest rates are high because they're over levered is really just not true. It's just that people tend to buy tech stocks when rates are rising and there's not that many tech stocks in the small cap index. I have nothing to do. They're basically borrow roughly the same as other companies do, maybe a little bit more but and maybe they have a little bit more floating, but it's not material. Okay, they're like 30% levered and 10% floating. It doesn't matter whether the rate's at five. So that's a completeness number, but so it's easy to select for great credits. Good growth rates Doesn't have to be a tech stock, so it could be a pretty mundane business like Casey General Store, just to have really good, profitable stores. They're adding them and I would emphasize what we were discussing before about this, because very few people seem to understand this, that the reason that it's not risky to hold stocks good stocks in the long run is these companies aren't expanding margins every year. A lot of pundits buy that, like in Casey's General Store. They're getting good returns from their existing stores, they're retaining earnings and they're building new stores. So if they just execute properly, in 10 years they're going to have a ton more money.

Speaker 1:

There's sort of a notion that it's a gamble that the returns on one store, like a McDonald's, goes to infinity. It's going to actually decline a little bit, so you need to keep building new stores. So all these companies are like that. They're retaining earnings growing up at rates that are attractive compared to their multiples. Um, woodward is a little bit more of a growth company because they, um are in the aerospace sector. So that is one where we have to look out a little bit further to justify the higher multiple.

Speaker 1:

But these are just solid, reasonably priced companies and I can just tell you from experience living through their earnings that we've just stocked the deck in our favor and most of the time they'll deliver and then the market solves the prize and they rally hard. So there's more opportunities, whereas if you go into a big cap print and it's like Broadcom or Amazon, you know everybody kind of has got all their bets laid, so that's really hard to surprise with the upside. So we do think that this methodology works particularly well on the small cap side. On the large cap side we'd probably get to. I think our biggest value out of there because a lot of people can trade large cap stocks is writing these individual short-term calls. So you'll see no index there, right, because we don't need it. We can write um. You know, goldman sachs was one of our best ideas for the year. Had been was a tremendous idea last year too, because you know, I used to be investment banker.

Speaker 1:

I can kind of tell when that market's heating up. This is like my investment banker tie, from being an investment banker so. But that company has good volatilities, high prices, and we're just, we're writing Friday calls, two-week calls, three-week calls, but we're monitoring it because we want to stay involved in the stock it expires. We make money. If it gets called away away, we'll buy it right there. So we're adding a tremendous in our not humble amount of value.

Speaker 1:

Because you have to be, as one of my analysts pointed out, a little bit psycho to do it like we do it all day long and you do have to monitor because you don't want to be like, oh, my best idea is goldman sachs and I wrote a bunch of calls and now you you know we have no upside to it you can only do it when you write really short-term calls and their decay is really high and you can afford to buy what's called Delta stock to offset it. So that's what JEPI can't do, because they have these closed-based notes and they can't do anything to offset the notes starting to run into the money.

Speaker 2:

And who's actually doing that, that trading on the option side, and how frequently is that moderate?

Speaker 1:

I mean, I'm a little bit nutty and I like doing it, so it's mostly me the analyst, the research team will do it, but usually at my request. So that's kind of like if you're say, one good thing I'm. One thing I'm good at is writing calls like it's possible that I've written more calls than anybody on. Well, I don't know this, but it's quite possible that that's true. Something I did not know about you.

Speaker 2:

I had no idea that you were constantly writing calls from that.

Speaker 1:

A little bit like actually our analysts pointed this out Uh, cause we did our hedge fund, it said, yeah, that's sort of proprietary, but I don't think there's anybody willing to do that, so I don't think it matters if you tell people that you do that.

Speaker 2:

Has anything changed when it comes to writing calls In the era of zero DTE? Yeah, it's way better.

Speaker 1:

The thing is that it used to not be that great, because you really even though it doesn't sound like a big deal.

Speaker 1:

So I can manage a Goldman Sachs call that expires on Friday. But a Goldman Sachs call that expires in three weeks on the quarterly I mean on the monthly expiration that starts to get tough. So Goldman's at 650, you know maybe, and I write up 665 on Friday it's a 663 or. But if I write it out three, four weeks on the monthlies it can run well above the call price, but I still, you know it doesn't get called away so I can't go buy more stock price, but I still, you know it doesn't get called away so I can't go buy more stock. So the key to large cap writing is to use the weeklies and that's why we don't do it in the small caps, for two reasons.

Speaker 2:

They don't have weeklies.

Speaker 1:

And also small caps are very digital, like they beat earnings and they're up 30%, or something bad happens and they're down, or they get acquired, like Goldman Sachs almost certainly not going to get acquired.

Speaker 1:

So you don't want to write a bunch of calls on something that's going to get acquired, so you have to in our opinion, to add value, focus on these weekly call options where you're getting a ton of decay but not capping your upside, and you can manage it because you're getting all these expirations every every week. But it's a little bit like Dave Leverman. Don't try it at home unless if you have a day job. You can do it if you don't but which we? We have a day job of managing our portfolios, but it's also good. Keep just really attached to the companies and you know, if there's a problem with stock, we don't just write a call, we go research.

Speaker 2:

it see what the problem is. Does the number of other fund companies, institutional players, writing calls impact their potential alpha generating future performance?

Speaker 1:

I mean, it seems like there's more and more people and more and more institutions and more and more money doing it, I guess but you know, you were pointing it out too like there's more and more people and more and more institutions and more and more money doing it. I guess but you know you were pointing it out too there's a lot more gamblers, yeah, and so we're kind of stealing money from the gamblers. I mean, you know like not I won't say their name, but these people used to go on SampyC. Now they advertise and every time they discuss something they were buying calls and my experience of that is that's a great way to lose money. But there are still a lot of people, particularly in better markets, who want to buy the NVIDIA Friday 242.50 call. So sold to them, or you know, we don't do this in our regular funds but in our hedge fund. We'll write out of the money like 900 microstrategy calls, you know, and somebody's buying them, you know, at least implicitly, buying them by. Maybe they're not buying that one.

Speaker 2:

Maybe that's a market maker, but they're buying some other call and bidding the volatilities up to ridiculous levels. One thing I think is interesting when I look at the holdings on ICAP is that there's a lot of variety of industries in general, sectors in general. It's not like it's overwhelming, from what I can tell, energy or any other part. Do you factor in benchmark sector weightings at all? Is it purely just?

Speaker 1:

Yeah, we do, we wanted to, we do, and though we're not afraid to take bets, so we are more focused on investment banks and large financials than the indexes. We have a little more energy Not a lot. We have a bad benchmark on tech, but we think we have the best tech companies by far that are less volatile, like an Amazon's kind of half Walmart, half Microsoft, so it doesn't really can write a lot of calls, but just kind of drifts higher most of the time doesn't blow up. So what's also great that I should have mentioned about writing these individual calls that doesn't work as well, for instance on AMCA, is another one of our funds. It's all energy Is that?

Speaker 1:

Let's say, we wrote a Chevron call to the top position right now and it all gets called away. Well, that's not great. We only write where we have a profit, so we're taking a profit on Chevron. And then we might say, well, you know, so we're taking a profit on Chevron. And then we might say, well, you know, I think energy is a little toppy here, so let's recycle that into a financial or a REIT. So we'd write fewer calls in AMZA, because when energy is running, everything is running, so something gets called away.

Speaker 1:

There's nothing else to buy because the whole sector moved up. But here we can use calls to kind of do forced sector rotations and it usually works pretty well because, like, for instance, southern Company is a good weekly call writer and I was an investment banker and I'm like the stocks are like 96. I just wrote it all up and we got it called away at 100. Now it's at 86. So you can make these sector calls as well, so that we're not like doing mechanical, just like um, you know, these index funds I've been picking on Just like okay, out three months we're writing the S and P 500. You can really get blown up doing that.

Speaker 2:

So you've got S cap, you got've got I-Cap. And then of course there's the newer fund on the bond side. Bonds have been a very tough asset class in general over the last several years Hard to raise assets in, I think, in general. But maybe the cycle is about to turn to your point. Rates are going to start falling disinflation.

Speaker 1:

Okay, that all should be a tailwind. Talk to me about BNDS. Well, we're excited.

Speaker 2:

We might be the most excited about BNDS.

Speaker 1:

I've never met somebody who's excited in bonds, yeah, but I'll tell you why. So our flagship plan is PFFA and we really launched that at a horrible time, so before the pandemic. So we had kind of everything possible go wrong. But what we found is, if you pick really good credits with good yields so quote higher risk, but not in our models, but everybody else thinks they are, so they have good seven, eight, nine yields and they don't default Well, guess what? You get Good returns through horrible markets. So we've gotten again look all this up, verify everything like around 8% returns for PFFA in a market where the index is at 4-ish.

Speaker 1:

So the index uses the same methodology, but what's great about it is preferreds have good total returns but much higher volatility than regular high yield bonds. They're not owned by institutions. Retail tends to panic during like pandemics, sell them to zero, whereas hedge funds will come in and buy Okay, well, I own the assets at 30 cents on the dollar, so I'll just buy it. I don't care what everybody else is doing. So bonds high yield bonds have about a third the volatility of the S&P but about a half the volatility of preferreds, but yet yields that are very similar. So if you want to add yield and you don't want to, you know, watch something gyrate around then high yield bonds are an excellent opportunity now.

Speaker 1:

We think rates are going to drop high yield and preferreds will do really well. But if they don't drop, high yields and preferreds will do way better than investment grade and other bonds. So, and like I said, as long as they're well curated, so you don't have a lot of faults, they're going to survive well in most markets that you're going to probably end up with the coupon-ish through long periods of time.

Speaker 2:

There's a clear argument to be made that when it comes to the bond market, you want to be active right, as opposed to equities in general. Is it your experience that it tends to be I don't want to use the word easier, because nothing is easy but relatively easier to find mispriced opportunities in bonds and stocks.

Speaker 1:

Well, absolutely. And there's a very simple reason for that it's the call price. So there's a limit to the upside of bonds and preferreds. So it makes it inherently challenging not impossible but challenging to outperform with equities. Because we know from like 21, the dumbest equities can go up the most. But if something's gobble at par and you sell it above par, you could get a hundred experts and they would all agree that would be a good sale, whereas if you sell NVIDIA at $120, nobody really knows. So because you're managing call risk, interest rate risk, credit risk, these are mundane things that need to be monitored and there's not like sort of two sides to it, like, oh, it's really low quality and high leverage. Well, in good markets that could be good for an equity, but it's usually not good for bonds.

Speaker 1:

So it's more precise, and what happens is the index funds don't care, so they end up buying securities from us, usually that are well above and far and making stupid mistakes. Not because they're stupid, but they don't. They're not, so they just follow. They don't have any rules and they just follow the index.

Speaker 2:

And when we talk about active in the fixed income space, is it fair to say the most important factor is default risk, the market's perception of default risk.

Speaker 1:

That and also now, like in good markets, just you have to constantly manage call risk. So if you look, I mean it's opportunity for us. So every day we sell securities almost in good markets, almost always because they're trading above their call price. And in fact, an interesting way to look at it is a lot of our clients ask us well, what's your turnover rate? And I think it's kind of meant to be a gotcha question, like, oh, you guys are psycho traders because you're turning the portfolio over. But actually, particularly in fixed income, the higher the turnover means the more opportunities there were to sell above par and buy something below par. So, like for instance, last year, I think we turned the portfolio over. 60%. Sounds high, but that's because we're selling all that. They got called away as well. So we didn't have a choice but selling things above par and buying them below. The year before that the market was depressed, so we only did 30. So it's actually better when the market's pretty stable and then we just take advantage of these easy opportunities to sell a blood part.

Speaker 2:

So I'm actually curious about this. I haven't read this question, but weighting is, when it comes to a bond portfolio, right. I mean, we know there's all kinds of interesting ways of weighting on the equity side, market cap, equal way fundamentally weird. How do you wait? Bond securities?

Speaker 1:

Well, we we do it similar to equity. So you don't want to take big bets on bonds. So, and because you know there are no game stops right, so nothing goes to infinity, so there's no real reason to get 10% NVIDIA or something like that. So we issue our size maximum five. Issue size keep right around three. It's for PFFA.

Speaker 1:

And actually you know we continue to reduce those limits because there's always opportunities to put profits A lot of security securities going above par. But every once in a while you know there could be a credit problem and you want to make sure the credit problem is immaterial compared to the opportunity to just sell above par. So something's a 2% position, maybe there's a credit issue. It goes down 30. That's like 60 base points. We can easily make 60 base points in like two months selling new issue of a bar.

Speaker 1:

So you want to you want to kind of stay in the game, grind out returns, not take bets and just be. Realize you're fallible. We haven't made any significant mistake. But companies do think we're not running the companies. They can do stupid things Not going to affect credit. But there can be fires in California. So one security came down a couple bucks, not a problem for it. But unexpected events can occur. So we don't. We're not arrogant about that and assume that you know bad things are going to happen.

Speaker 2:

So I got to ask somebody because this is always a nag to me, using that word mistakes uh about that? And assume that you know bad things are going to happen. So I gotta ask something, because this is always a nag to me, that using that word mistakes in our industry to me is always a strange word to use, because the natural inclination is to think that a mistake is something that had a loss, but that may not be a mistake. That just may be the single rule to die. So how do you know what actually is a mistake, from sort of a self-evaluation investment committee perspective, what actually rides it to the level?

Speaker 1:

Well, you know, what's really spectacular about our process is it's 100% quantitative. Okay, so the security I was referring to is Southern California Edison Preferred J. Now, that is a bond, by the way, so the bonds of utilities essentially never have a loss, but that was a horrendous fire in California. So what we did is you know, I'm a utility former utility banker, so better than most of doing this former utility banker, so better than most to doing this we went in, read the law, realized they were going to take probably a three billion hit to their what's called rate base, lowered our earnings estimates. We did own some of that stock in iCap and we sold it fifteen dollars ago, I think, um, and I think that stock will remain under pressure, but the debt is totally fine because there is a $25 billion fund in California to protect the bondholders, in effect.

Speaker 1:

So we put all that into our models, looked at the upside again. In the case of the equity, we sold it. In the case of the bonds, we bought more, but it's a quantitative. So something has to change, changes the forecast. It's not just that you know we get disgusted with management or don't like that. Elon Musk is doing something. It has to impact our forecasts and our relative valuation. And if you do that religiously, you'll avoid making stupid mistakes. Where you like, overreact, toact, to like the fact the stock's going down or up.

Speaker 2:

Jay, there's a lot of things we covered here. I'm sure there's a lot of people listening that would be curious to learn more about the funds and are, in general, more interested in hearing more from you. Where would you point them to for those who want to learn about the funds and who want to track more of your own about the?

Speaker 1:

funds and who want to track more your own work. If you go to wwwinfracapfundscom, you can sign up for our mailing list. We do pretty unique research, as we were describing, Do a monthly webcast. You can ask us questions, Like we actually like talking to clients. I will respond or somebody will respond. We'll get on phone calls with clients big and small clients so that's one. We'll get on phone calls with clients big and small clients so that's one. We do believe in client service. We like talking to our clients. We learn a lot from our clients. They ask good questions, so I would offer that up as a unique value proposition. We're not like Larry Fink, you know, talking about climate change. We're here in our offices.

Speaker 2:

We're counting portfolios, occasionally talking to people like yourself, but happy to talk to more and, before we leave, talk to me about what you're going to be presenting on at the Money Show. You and I are going to be doing a couple of interviews live on stage, but what's the main presentation on?

Speaker 1:

Well, we have two presentations. We always do. We talk about macro, which I think is, you know, very interesting to a lot of people, but then we just lay out equity income alternative. It's not just our funds, because our real message to people, particularly if you're a little more conservative, is build substantial income so you can sleep at night. So build 3%, four, five percent. Don't have to all use our funds. Look at all the risks and the return rewards, because without risk there's no reward. So you're either taking interest rate risk or stock market risk. We have that well laid out. So it's a good. You know we want people to run their own portfolios and use our securities, not just be like blindly trusting us to run everything.

Speaker 2:

If you happen to be the only show folks, come with me. Come visit Jay. We'll see some of you there. I might even be live streaming it on spaces. This is a sponsor conversation by Jay Hatfield's firm Infrastructure Capital and hopefully I will see you all on the next episode. Thank you, Jay, appreciate it.

Speaker 1:

Thanks, michael, it was great.

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Michael A. Gayed, CFA

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