How to identify businesses that can land on their feet

Investors must seek out financially resilient businesses as a small issue one company must rush to address can end up proving more dangerous than a larger problem another company has the luxury of time to deal with

19/10/2020

Juan Torres Rodriguez

Juan Torres Rodriguez

Research Analyst, Equity Value

Investors can learn lessons from the most unlikely of places so we should not be too surprised there is one to be gleaned from the survival rates of cats that fall out of tower-block windows. In a blog entitled The Ugly Scramble, investment commentator Morgan Housel, whose new book The Psychology of Money is already a best-seller in the US, highlights a piece of research two New York vets carried out in the late 1980s.

Moved to investigate what happened to cats unfortunate enough to slip from the windows and ledges of high-rise buildings, the pair came to a highly counterintuitive conclusion. Rather than the extent of a cat’s injuries being more severe the further it falls, the vets found the relationship between the height of a cat’s fall and the injuries it suffers is an upside-down ‘U’.

In other words, as Housel explains: “A short fall is safer than a medium-height fall. But there’s a point where the further a cat falls, the less injury it’s likely to face.” There appear to be both physical and psychological reasons for this, with a cat relaxing more when it reaches terminal velocity and thus spreading out its legs so it ‘glides’ – to some extent – in the manner of an urban flying squirrel, thus allowing for a gentler landing.

Falling cats, scrambling businesses

You can, if you wish, find more detail in the above blog but Housel goes on to draw an analogy between falling cats and businesses scrambling to survive the fall-out from the Covid-19 pandemic. “Risk depends on how hasty your response must be,” he observes. “A small problem you have to scramble to protect yourself from with a snap judgement can be more dangerous than a larger problem you have time to deal with.

“Every business will be impacted by Covid-19. Some worse than others. But one of the biggest differences in how much permanent damage 2020 will cause is whether a business has to scramble to protect itself or calmly deal with the new world.” Housel then notes the contrasting fortunes of two US airlines – one that has had the luxury of time to think through a solution to its current predicament and one with no such breathing space.

How well-placed (or not) different companies are to cope with the unexpected goes straight to the heart of our investment process, here on The Value Perspective. Indeed, given the year so far, we have addressed this repeatedly in recent months in unambiguously titled pieces such as Why you should, frankly, give a dam about company balance sheets and Why balance sheet strength should interest investors more than ever.

Rock-solid balance sheet

In essence, our process is designed to put risk front-of-mind by meticulously analysing businesses to ensure they are so financially resilient they should have the time to weather any kind of crisis. A good example of this is a diamond miner we own, which at the start of the year boasted a rock-solid balance sheet with a net-debt-to-EBITDA (earnings before interest, taxes, depreciation and amortisation) ratio of 0.8x.

After generating $3.7bn (£2.9bn) in revenues in 2019, the company saw diamond sales flatline in the early months of the pandemic – and indeed these are only just beginning to recover. Despite year-on-year revenues plummeting more than 80% in the second quarter, however, the company has pursued a bold strategy – opting to sustain the price levels of its product, even at the risk of collapsing volumes.

So how on earth can this business survive such a drastic course of action? It has been able to do so because it had a very strong balance sheet going into the crisis and this has allowed the time and flexibility for the business to take some painful measures. Yes, its balance sheet has naturally deteriorated a bit but, at around 1.56x net debt to EBITDA today, it remains relatively strong.

Given Housel’s blog ends with the best cat pun for the circumstances, let’s give him the final word. “To me the most universal lesson of 2020 is the value of room for error,” he says. “Avoiding, as much as possible, the scramble of making snap decisions because you don’t have time to think through a problem with a deliberate long-term strategy. Embracing, as much as possible, anything that gives you time, options, and flexibility.

“Like a cat with nine lives.”

Author

Juan Torres Rodriguez

Juan Torres Rodriguez

Research Analyst, Equity Value

I joined Schroders in January 2017 as a member of the Global Value Investment team. Prior to joining Schroders I worked for the Global Emerging Markets value and income funds at Pictet Asset Management with responsibility over different sectors, among those Consumer, Telecoms and Utilities. Before joining Pictet I was a member of the Customs Solution Group at HOLT Credit Suisse.  

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