Hello Smart Investors! I hope you’re doing OK out there during the hard times we’re going through these days.
Today I would like to start a series of posts that will elaborate in depth on why some of the specific SIA assumptions are as they are . Let’s call this series Deep Dive into SIA.
Let me just remind you the SIA again:
* „I don’t have to, I can” attitude
* no benchmarks
* cycle-adjusted portfolio allocations helping risk control
* concentration on the world’s best assets
* avoidance of debt overload
* maximization of effects with minimalization of efforts
* each stock must undergo a so called SIA Score process before qualifying into the portfolio:
S1: growing sector 1pts/0pts,
S2: incumbent or prospective global leader 1pts/0pts,
S3: growing or stable wide margins (40%+ gross; 3yr avg) 2pts/0pts,
S4: Net Debt/EBITDA <1.5 (last 3 ended FYs) 2pts/0pts,
S5: above-average cash flows (last 3 ended FYs) (FCF/MktCap > S&P500 Dividend Yield or US 10yr Treasry Yield (higher of the values)) 2pts/0pts;
MAX TOTAL SCORE: 8pts/MIN TOTAL SCORE: 0pts/MIN SCORE TO QUALIFY: 4pts
Today I will touch upon the “avoidance of debt overload” part of SIA and S4 point of SIA Score.
Capital structure considerations
A company’s capital structure is actualy one of the most important decisions every management has to take, while running the company and involving in any new projects. Every targeted structre of debt to equity managers would ever decide to pursue has to have one basic idea in mind – the idea of shareholder value maximisation, which is the very basic principle of capitalism. Shareholders always take the biggest risk of all capital providers and should be appropriately rewarded for it. Equity part of the balance sheet of a company is always the first to be wiped out in case of financial distress. Debtholders’ claims are always filled ahead of shareholders’ claims. Yet ahead of them come contractors, banks and of course the state. It is no wonder then that managers of any company should consider the interest of the least privileged group – the investors.
Higher intebtedness has one basic undeniable advantage – it increases a company’s tax shield. Most countries in the world subsidize debt financing by making interest paid on debt deductible from taxable profits. This means lower taxes paid by companies using leverage versus what they would have to pay, if they were financed purely by equity.
But, and there’s always a but, every stick has two ends. If a company increases debt to a level where it can no longer service its debt (interest payments plus paying back face value of debt), it falls into financial distress. Reasons for why it’s not able to service debt any more can be plentyfold, be it management mistakes by capital allocation, sudden deterioration of business conditions caused by external factors (recession or slowdown), fall of demand for the company’s products, sudden increase in market interest rates, mistakes in working capital (liquidity) management or other. Every company has different optimal debt levels it can and should target, dependant on such factors like: specific business risk (high risk businesses surely will face higher costs of financial distress (default or bankruptcy)), tax situation, assets it owns (companies with high level of goodwill for instance will as a rule face bigger problems in distress as their assets will erode rapidly vs. companies with high share of fixed assets), financial buffer a company may employ should new investment opportunities arise (some call it financial slack). A reasonable attitude to debt should, in my opinion always look like this: (1) stable recurring business + relatively big share of marketable tangible assets => higher debt levels may be accepted OR (2) riskier but with higher growth potential business with less steadily recurring revenues (but higher value potential in the future) and higher share of intangible assets => lower levels of debt shall be accepted (or ideally none).
Please bear in mind that one of SIA’s other assumptions is “concentration on the world’s best assets” depicted in SIA Score mainly by S1, S2 and S3 (this is what the “best assets” part really is meant to represent). This implies that most of the stocks that will ever be included into SIA-style Portoflios will rather have more characteristics of option (2) rather than option (1).
Does debt really matter?
Back in 1958 two American gentlemen named Franco Modigliani and Merton Miller wrote an article published in the American Economic Review called “The Cost of Capital, Corporation Finance and the Theory of Investment”. It actually turned out to be one of the most important pieces in modern theory of finance. Both authors were later widely appreciated (among their other works also for this article) and awarded Nobel Prizes (Modigliani in 1985 and Miller in 1990). Let us call this tandem “MM”.
The major conclusion of MM article was that in a theoretical world of perfect markets the capital structure of a company does not have any impact on its value. What is meant by perfect markets? These are markets without transaction costs, taxes and other imperfections, plus they are effective – any information is immediately priced in (arbitrage is non-existant) and market valuations depict the real value of any firm under consideration. In such conditions equity or debt issuers are not able to sell their claims (be it debt or equity) above their true value, which is equal to present value of the future cash flows these claims represent. Should an issuer try to sell a claim above the real value, there will be automatically an endless amount of investors willing to give money dumping the price of a claim back to its real value, and should the issuer look to sell below real value, there will be noone to give money to the issuer. As a rule equity investors demand higher returns (as they carry the higherst risks, see above why), whilst debt investors demand (on average) smaller returns as their claims are purely contractual to the issuer and they do not take financial part in the value growth of the issuer. All this leads to a situation where an issuer is not able to incur a profit or loss only by changing its capital structure. MM’s conclusion was that since no P&L can be produced by increasing/decreasing debt in a company’s balance sheet, the capital structure has no bearing on the value and the average cost of capital a company pays (depicted by WACC – Weight Average Cost of Capital). You can read more about MM theorem here.
The problem is, as with most theoretical deliberations, that perfect world and perfect markets do not exist. There’s always taxes, there’s always some sort of costs, there’s always unequal access to information or there’s just misinformation. Even though MM theorem made its way into the very mainstream of finance education, it was pretty heavily negated by market practitioners, because of the ommittance of impertections, which are plenty in the real world. Hearing that MM duet made and improvement to their theory and incorporated taxes as part of their model. Conclusion? In a world with taxes capital structure does affect the value of a company. This is mainly because of tax shield created by the fact that interest on debt are tax deductible throughout the company’s lifetime (assume perpetuity) . In such a case:
Value of Leveraged Firm = Value of Unleveraged Firm + Permanent Tax Shield where Permanent Tax Shield = Tax Rate x Debt Value x Interest on Debt.
And also: the higher the tax shield, the lower the WACC after taxes a company pays. [WACC=Equity/(Debt+Equity) x CostofEquity + Debt/(Debt+Equity) x CostofDebt x (1-TaxRate)].
Conclusion: the higher the debt share in capital structure, the bigger the tax shield => perfect share of debt is 100% (maximal tax shield and lowest effective after-tax WACC).
Is 100% debt financing really the perfect fit then? No it’s not. In reality most companies using debt financing do not trespass 50-60% of debt in their capital structure. And that because of a couple very basic reasons:
(a) Costs of Agency – these are the costs shareholders always have to incur to pay the managers of their company (all assumed managers and shareholders are not the same persons as is the case in smaller companies). Salaries, bonuses, any other perks like autos, planes, etc, etc. IT’s effectively all just costs that decrease the value of a company. IT’s especially true when a company uses debt financing. Managers can be then vulnerable to using debt financing for risky projects (with low probability o delivering positive Net Present Value (NPV) or even bringing negative NPV) in a tiral to increase shareholder equity, to which most often the managers’ bonuses are linked. Such behaviour transfers value from holders of debt to equity holders (and the managers most often as well), but overall mostly leads to a decrease of overall company value. So the bondholders will always be interested to impose certain limits on a company’s management and shareholders that will increase the possibility that the company does not get involved in too risky projects and businesses. They will impose so called covenants to protect themselves from the company defaulting by mismanagement. Such a covenant can be for instance certain NetDebt/EBITDA levels (most commonly used lvls are between 2,5-3,5x, but it differs from country to country, sector to sector, etc.). NetDebt/EBITDA basically tells you how long (in years) it would take for a firm to pay back its debt, should it decide to spend all its operational recurring income on the repayment). There’s also other covenants of course, but that’s a story for a different article. Bondholders can also try to limit dividend payments to shareholders. All this leads to lowering debt share in the capital mix.
(b) Costs of Bankruptcy – when a company looses its ability to service its debt smoothly it defaults. Probability of a default is a function of debt. If a firm has high levels of debt relative to equity it becomes more and more dependant on any ups and downs in its business (falling revenues, worsening operational margins, etc.). When it defaults, it can be called into bankruptcy by the ones that lent money to the firm, beacuse they will look to get back their claims (the face value of debt). This can happen through restructuring (bondholders dilute current shareholders and gain control over the company) or through liquidation (firm is closed and assets are sold off; contractors, state, banks and bondholders are paid off proportionately with the proceeds from the sale of assets and equity holders take what’s left, if anything). Costs of default/bankruptcy can be very high and destructive to the long term value of a firm (higher future cost of capital, loss of crutial employees, lost of goodwill or value of trademarks). That’s another reason why in real life you won’t find a firm finacing its needs solely with debt.
(c) Fraudulent Behaviour – firms with high level of debt can easily fall in a vicious circle of avoiding bankruptcy around the corner at every price by undertaking more and more risky businesses, which (as the managers of such company may think) will surely pay off big time and get the firm back up and running normally.
At some point all the above costs’ marginal added value is negative. A company keeps increasing its debt, but it can no longer increase the positive effects of higher tax shield nor lower its WACC. So, LEVEL OF DEBT DOES MATTER AND IT MATTERS HUGE ESPECIALLY FOR SHAREHOLDERS, whose interest in and control over a company can be wiped out down to ZERO. Thus it is extremely important that and investor uses maximal caution while investing in companies with a substantial share of debt on their balance sheets. As I mentioned at the start of this post, one also always has to compare the type of a stock to the debt level as well. Example: Electicite de France SA, the biggest French electric utility, has a 2,6x NetDebt/EBITDA level and Long Term Debt/Equity ratio at over 100% (as of end 2019; source: Bloomberg). This seems a lot, but EDF has extremely stable recurring income that is sure to persist at easily predictable levels in the future and tangible assets stand at as high as 94% (same source). EDF is a very renowned brand and has/will have no troubles finding new financing without increased costs. The risk of EDF falling into default is thus very small. But, EDF does not give an investor growth potential, operates mostly in the conventional power generation segment and is subject to EU consumer protection regulations. On the other hand Enphase Energy Inc. (ENPH), one of the US leading solar energy power solutions companies, has respectively: NetDebt/EBITDA at -1.1x (the company is cash positive) and Long Term Debt/Equity ratio at 41% (as of end 2019; source Bloomberg). ENPH has much less stable and riskier income, but its growth is much higher on the other hand, plus it operates in renewable energy sector, which is very dynamic and lets investors assume much higher value of the firm in the future. That’s why ENPH finances growth mostly via equity. And that’s the right thing to do. If ENPH management would decide to subtantially increase debt share, it would expose the copmany to all the risks mentioned above.
To sum it all up, a Smart Investor would say: finance Growth with equity, finance Value with debt. A Smart Investor likes Growth though! So a Smart Investor prefers equity over debt financing!
In the next Deep Dive into SIA (promissed soon) I will try to elaborate on S5 part of SIA Score. Namely I will try to answer the question on whether a Smart Investor should prefer dividends in hand now or higher Free Cash Flows (Dividend Yield vs. FCF Yield). The MM duet will be helpful again here, supported by Mr. Myron J. Gordon. Stay tuned!
Best of luck,
Disclaimers: None of the ideas, views and thoughts presented here shall ever be taken as a recommendation to buy or sell stocks,bonds,FX,commodities or any other financial instruments as stated in REGULATION (EU) No 596/2014 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 16 April 2014 on market abuse (market abuse regulation) and repealing Directive 2003/6/EC of the European Parliament and of the Council and Commission Directives 2003/124/EC, 2003/125/EC and 2004/72/EC or the Regulation of the Polish Minister of Finance of 19 October 2005 on information constituting recommendations regarding financial instruments, their issuers or exhibitors (Journal of Laws of 2005, No. 206, item 1715) or the Polish Act of 10 February 2017 amending the act on trading in financial instruments and some other acts. The article is for educational reasons and purely presents private views of the author, thus the author shall not be claimed eligibile for any losses of a third party resulting from trading activities based upon this article. The author uses his best knowledge and data from sources believed to be reliable, but makes no representations as to the accuracy of the data. Full Disclaimers&Liability Limitations page.