Growth is perhaps the easier to define: does the company have the tools at its disposal to compound earnings at an attractive rate over time. Relevance and sustainability has sharply diverging meanings depending on who one asks. Our preference is to cast the net as broadly as possible: simply, a company whose current earnings to do not borrow from its future earnings. This concept is wide ranging and influences the fund exclusions. Tobacco for example, where new customers must be found to offset the natural elimination of the existing base by the product itself. Old energy with the extensive disruption from renewables already in full swing. Banks, where inherent leverage hangs like a sword of Damocles over the thin slivers of equity that supports it.
The idea of a sustainable business is also interwoven into our investment process; how does the company treat its stakeholders, is adequate capital being invested to support the economic moat, how aligned are management, are cash returns in excess of the cost of capital, is leverage employed conservatively, to name a few. Used prudently, leverage can support growth and optimise the cost of capital for a given business. Used imprudently, it results in a front-loading of returns and increasing vulnerability to future shocks. A decade of easy money, unspectacular economic prospects and rising corporate margins have nudged many CFOs, particularly in the US, down the path of least resistance, that of financial engineering.
The results are stark: US corporate leverage has doubled when compared to 2007. Excluding banks, net debt to EBITDA ratios now stand at 1.8x, just below the 2x above which issuers tend to be viewed as sub-investment grade. The median leverage of the 27 Global Leaders is just 0.6x.
A good proxy to mitigate downside risk is the avoidance of fragility. As the essayist and fund manager Nassim Taleb* proffered, “it is far easier to figure out if something is fragile than to predict the occurrence of an event that may harm it. Fragility can be measured; risk is not measurable”.
Who can say how fast rates will have to rise to temper the heat of the US economy? It may be that overleveraged corporates will find the space to gradually paydown debt before any recession. This is possible but by no means probable. Indeed, as the cost of capital rises, corporate indebtedness is likely to be source of increasing angst for investors, in our view. As Mr Buffet famously quipped in 2008, “you only learn who has been swimming naked when the tide goes out”.
*Antifragile: Things that Gain from Disorder (2012)