Ducking and diving to survive stormy times
Differing investment styles have come to the fore amid another tough period for global financial markets.
The way in which companies expand and leverage their balance sheets are often reflecting these variations in style, and can lead to calamitous outcomes if not managed well.
Broadly, I have found North American based investment managers have a greater appetite for risk than those based in Europe.
This US approach will often encourage management teams and their boards to adopt an aggressive attitude in managing debt on balance sheets.
The reasoning is simple. By incurring relatively high debt levels a company with strong cashflows can quickly eat in to borrowings.
In doing so they turbo-charge the value of equity and create strong returns.
In Europe, generally a more conservative approach is widespread. Investors are wary about loading too much debt on to balance sheets.
They are willing to live with lower levels of returns in exchange for balance sheets that lightly geared.
These businesses are then better equipped to handle any downturn in their end markets.
During the global financial crisis after 2008 the US investment style led to major collapses of companies that encountered shrinking cashflows amid high levels of debts.
That forced them to breaking point and many went bust. Conversely, companies with low levels of debt not only survived but were primed to pick up some juicy pieces left by over extended businesses.
This debate about an optimal balance sheet structure is alive once more in recent weeks as volatility has grabbed global financial markets by the neck.
After a period of serene calm, especially in the Irish economy, both investors and management teams are having to duck and dive as forecasted economic growth wavers amid trade wars and Brexit in particular.
I remember working with one company that had a bullet proof balance sheet, very solid cashflows and strong market shares.
A US investor acquired a stake in the company and commenced a campaign to overhaul the financial metrics used by the company.
Letters were sent to the management team and the board explaining this investor’s logic.
The company had a balance sheet which could absorb a dramatic increase in debt.
By taking that on the company could engage in accelerated investments and share buybacks that would quickly lift the value of each share held in the company.
This investor wanted action quickly so that they could see a positive share price.
A battle ensued between a company more focussed on the long term and an investor thinking short term.
The company eventually prevailed and that investment company actually itself failed within a year.
If the investor’s advice had been accepted I suspect the company would have got in to trouble because its end markets proved very choppy over ensuing years.
Thankfully, it resisted the pressures but it was a salutary lesson.
As time goes on I am more convinced than ever that companies need to adopt highly conservative balance sheet strategies if they plan to build long term value.
That is not a code for being slack about ambition. Companies can be hard driving and scale up by re-investing and using moderate levels of debt to augment their core competitive advantage.
Yet, they must do so while ensuring the business is battle ready when economic conditions change.
It is inevitable, Brexit or no Brexit, that the world economy will slow and possibly contract over coming years because it has done so repeatedly over the past century.
Over leveraged companies should fear that while those equipped with plenty of financial headroom can not only batten down the hatches but have the ability to surface faster than others when the economic storm passes.
If well managed, such an approach can steadily create a business that consistently grows while others veer from boom to bust.
