The manifestations of leverage
One of the big picture themes currently dominating the investment landscape is the financial repression brought about by central bank policy aimed at transferring wealth from savers to borrowers in order to deleverage the economy from currently unprecedented levels. Within small caps we are seeing the effects of this in a number of ways.
Compression of yields
The pursuit of yield has resulted in anything with a dividend greater than that available from a term deposit being bid up significantly. As term deposit rates follow cash rates downwards we should probably expect a continued bid for securities with this characteristic, however we continue to believe this is an artificial distortion of security prices brought about by central bank policy. This has most likely brought forward future returns in these stocks making them less prospectively attractive as an investment than 12 months ago.
Compression of security yields tend to be the first symptom of financial repression as the frictional cost of buying securities is relatively low. We have observed this first phase of yield compression in the small cap market through the outperformance of traditional yield driven securities – property trusts, infrastructure, utilities and telecommunication stocks. All of the more significant small cap property trusts, or REITs, as they are now known (Charter Hall Retail, BWP Trust, Charter Hall group and Challenger Diversified Property Group) have outperformed the small ordinaries index, as have the larger telcos (Telecom New Zealand, Chorus, Singapore Telecommunications CDI and TPG Telecom). The infrastructure and utilities names have not only outperformed the small cap index, but have in the space of 12 months largely exited the small cap universe either through performance and migration into the S&P/ASX 100 Index (SP AusNet) or through being the target of takeover activity (Hastings Diversified Utilities Fund, Australian Infrastructure Fund). Although now of limited relevance to small cap investors, given the few investment opportunities that remain in infrastructure and utilities, we would observe that these equities are not without risk as the confidence in the operating cashflow has been offset by a matching amount of financial leverage meaning that equity holders may still be exposed to unexpected changes in the rate of asset returns as may come about from a change in the regulatory framework in the case of regulated utilities.
Debt fuelled M&A
As the repression continues, bank lending standards are relaxed (availability of credit) and lending spreads decline (price of credit). This continues until eventually the fiscal conservatism taken to heart by company directors (“never again!”) is overwhelmed by the lure of cheap credit funding M&A that is both strategically attractive and now financially saleable to shareholders. Just think of all that EPS accretion! The latest quarterly Federal Reserve Senior Loan Officer Opinion Survey on Bank Lending Practices released on 31 October 2012 shows exactly these trends in the US market – with standards for commercial and industrial and commercial real estate loans continuing to ease and spreads over bank funding costs continuing to decline. Although demand for commercial and industrial loans has yet to rise to the bait, there is no such hesitation in the commercial real estate sector where demand is notably increasing.
Our concern is that most people (directors, management and, goes without saying, their advisers) are excited by the lure of the deal. Not only do shareholders face the obvious risks of acquired goodwill and financial leverage not working out quite like management and their advisers expected, but there is also the opportunity cost of not giving the focus to the greatest level of value added available to most companies – organic growth. This is the hard stuff such as research and development, new product innovation, investment in productivity, sales and marketing, expansion into new market segments or in response to emerging customer demand etc. Watching companies small and large over the last couple of years focus inwardly on their organic opportunities has been satisfying for investors who believe that there are few silver bullets in long term commercial success. However, we are not naïve enough to think it was purely a result of company directors and their management teams finding organic growth religion – it was more a matter of a lack of options.
If we are about to go through another cycle of debt funded M&A the focus on executive compensation structures is even more important. Over the past couple of years, for the first time seemingly ever, there has been genuine director engagement in the structure of incentives for management such that long term alignment of interest is created between themselves and shareholders. Should we get the alignment and the definition of value creation right then management would have a very strong incentive to resist the value destructive behaviour that has accompanied pretty much every debt fuelled M&A cycle in history. Our concern is that whilst there was engagement and the conversation was headed in the right direction, in very few instances have these incentives been introduced and without them the cycle will play out as those before.
We suspect that in addition to watching out for those companies still burdened with too much debt, we will have to undertake a rear guard action and look out for those companies transforming the risk to equity holders through debt funded M&A.
Excess financial leverage
When we outlined our broad cyclical investment strategy in our June 2012 commentary, we made note of being wary of the number of small companies that are still carrying excessive financial leverage – often as a residual hangover from the last debt fuelled M&A cycle between 2004 and 2008. Investors were provided a reminder of this when TPI announced a 6% decline in 1Q13 EBITDA at their AGM on October 31st, which due to their high levels of operating leverage, and even post two equity recapitalisations a very high level of financial leverage, translated in analyst forecasts to a 30% reduction in pre-tax profits should this 6% EBITDA decline be applied for the full year. We remain wary of financially leveraged companies for the very reason highlighted by TPI – small negative changes to operating performance results in large reductions in cash flow available to equity holders and we continue to believe the operating environment for most domestic companies carries downside risk.
TPI is not alone as an industrial company having a balance sheet that is in our view carrying too little equity in the capital structure. Other small cap companies that have similar levels of debt relative to, in many cases uncertain operating earnings, include Transfield Services, Billabong International, Ten Network Holdings and APN News & Media. There are also businesses who, in the face of current operating conditions, look to have sufficient equity coverage but have historically seen operating leverage at a level that can make even current debt levels become uncomfortable very quickly. Companies such as Bradken, Ausdrill, MacMahon Holdings, Nufarm, Southern Cross Media, Pacific Brands and Emeco Holdings. Finally, there are companies who carry significant operating leverage commitments and have compounded this with financial leverage and here we are talking about specialty retail stocks including Super Retail Group and The Reject Shop.
Leveraging the credit spread
There is one other category of small cap stocks that has quietly been doing very well after having stared death in the face only three years ago and that is the small cap lending sector. These companies are effectively spread businesses that need two ingredients to make money: 1) they need available credit in order to fund loans; and 2) they need customers with limited alternate sources of funding who will pay their exorbitant rates. The business model uses the combination of a high ratio of assets to equity and a wide spread between the cost of funding and the effective interest rate charged to customers to generate returns to shareholders. There is a very good reason that they can achieve such a large spread with limited competition and that is often due to the higher risk of the lending activity undertaken. Occasionally it is due to small market niches not available or not large enough to appeal to mainstream lending organisations, but more often it is simply a difference in credit risk appetite. Institutional competition is not present in this market. It is questionable whether these businesses generate positive economic value through a complete business cycle and when combined with the potential brand damage associated with this type of lending activity it is hardly an area institutions have high on the opportunity list. Indeed witness the positive reception by the market to the sale of AGC by Westpac, acquired by GE for less than book value in 2001.
The precipice was faced a few years ago when funding for small cap lenders all but dried up and the pressure on customers saw an increase in the concern over bad debt risk. The bad debt risk didn’t materialise in Australia within this sector in any way like it occurred in other markets and that is almost entirely due to our domestic economic performance through the GFC. Should we face a level of GDP contraction as recently observed in the US, UK and Europe, then there is little doubt our credit experience will be more similar than different. As it stands today credit is flowing, funding costs are declining and customers are still in a pretty good financial position while being shunned by mainstream sources of credit. As such there couldn’t be a better set of conditions for the asset / equity leverage to express in high rates of equity return. Share prices for stocks such as FlexiGroup (currently trading at 6.7x net tangible assets), Cash Converters (3.9x), Thorn Group (2.6x) and Silverchef (2.9x) have been some of the best performers this year. The question investors have to ask now is for how long will these favourable conditions last and what is the risk should either funding availability or credit risk change.
Debt is an interesting condition to observe as an investor. It can quite clearly tell you that risk exists with almost no indication of when that risk will materialise. One investors’ excess leverage is another investors’ way of compounding short term operating momentum into higher rates of equity return. In the best case scenario the timing difference allows for the amortisation of debt down to more appropriate levels while the worst case scenario, well unfortunately we have seen that up close and it isn’t pretty. The only positive thing to be said here is at least losses are capped at 100%! Ultimately any strategy that pays off based upon the sequence of very short term events looks more like speculation than investment to us and we remain acutely aware of the risk financial leverage implies to our equity investments regardless of the path we may travel.
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