In a world of artificially low interest rates, public market investors seem to be rewarding one thing: growth. However, I have always had a preference for lower growth companies with extremely stable/predictable revenue streams, great cash conversion and a sensible capital allocation policy. This investment philosophy describes the type of investments many Private Equity firms target and I’ve often said that my personal style resembles a private equity approach to the public markets. In this blog post I want to discuss how investing in tortoise-like companies can still allow one to generate very attractive returns when a great entry price meets a skilled capital allocator.
First, I thought it would be useful to discuss some of the key advantages modest growers have over their high growth peers:
- High sales growth means that your new customers will quickly outnumber your existing ones, leading to new demands (investment) and unknown loyalty
- Rapid growth tends to attract competition
- Firms with a high growth outlook, usually demand a high multiple/valuation
- Growth can allow certain issues to go overlooked, but not indefinitely
- High growth usually requires continued investment in expanding the cost base to handle the increased turnover which can lead to poor decisions and or/ an inflated cost base for when growth slows
In a nut-shell, high growth is hard to manage and usually attracts competition. Slow growth, driven by recurring revenues from a familiar group of customers is much easier to manage and predict.
The two most important factors to consider when investing in a tortoise are:
- The initial price you pay
- The way the management team allocates the excess profits
Firstly, if you’re going to acquire a low growth business, you need to ensure you don’t over-pay. Unlike fast growing companies which can provide forgiveness for over-paying, much more of the value for a low growth business is present in the earlier years of a discounted cash flow. Therefore, you ideally want to pay less than fair value for the company so that you can get “multiple expansion” when you finally exit the investment. This means that if you pay 10x free cash flow for a business, you want to sell if for more than 10x at disposal.
The second, and arguably more important, factor is to find a management team who is aligned with shareholders and has a history of intelligent allocation of capital. A good capital allocator can take a business growing at 5% and generate >15% internal rates of return for investors through savvy use of the companies excess profits.
There are three main uses for excess capital within a business:
- Return the capital to shareholders via a share buy-back or dividends
- Pay down outstanding debt
- Make acquisitions
Returning capital and making acquisitions are the two most common uses of capital, however, I want to spend the majority of this blog discussing the repayment of debt, because I believe its “value” is misunderstood by investors and management teams. The math behind how repaying debt can generate value for shareholders is the same that underpins the leveraged buy-out technique used by private equity.
To explain the logic, keep in mind the following equation:
Enterprise value = market capitalization + net debt
The basic idea is that, as you reduce the net debt (by using excess cash to pay-down debt), the market capitalization must increase to ensure the equation remains balanced.
i.e. If we have a business with an market capitalization of $100m and net debt of $20m, the enterprise value will equal $120m
EV = MC + ND
EV = 100 + 20
EV = 120
Continuing this example, let’s assume the company repays all of it’s outstanding debt and now net debt equals zero. What will happen to the market capitalization?
EV = MC + ND
120 = MC + 0
120 = MC
The market capitalization has increased by 20% to offset the decline in net debt. This is how you generate value for shareholders through the repayment of debt.
Let’s use a more complicated example to show how attractive the returns to shareholders could be:
- Sustainable earnings: $10m
- Leverage: 4x
- Net debt: $40m (4 x $10m)
- Enterprise value: $75m
- EV multiple: 7.5x ($75m / $10m)
- Market cap: $35m ($75m – 40m)
If we assume the business can repay the $40m in debt outstanding within 5 years, we get the following IRR (annual investor return) calculation:
Enterprise value = market cap + net debt
$75m = MC + 0
Therefore, market capitalization has increased from $35m to $75m (a 2.14x increase)
Entry price: $35m
Exit price: $75m
Duration: 5 years
Now 16% per annum is an impressive shareholder return given it requires no growth in the existing business, however, the upside from this form of capital allocation comes from an increase in the multiple the business is valued on as net debt decreases. The logic behind this expansion in multiple is that as a business reduces it’s leverage, it becomes more financially sound and, therefore, its equity should be valued higher. If we continue with the example from above, but assume the multiple increases from 7.5x at the time of purchase to 10x at the time of sale, once the debt has been repaid, we generate the following IRR’s:
Entry price: $35m
Exit earnings: $10m
Exit multiple: 10x
Exit price: $100m
Duration: 5 years
That is how you can generate “guru” like stock market returns, with a no-growth business.
The other forms of capital allocation are more straight forward, but a quick analysis (with some rigid assumptions) gives the following basic matrix:
This is a little more difficult to translate from theory into reality, because it assumes the stock can be re-purchased at the same valuation (multiple of earnings) each year. However, it does show you that through re-purchasing shares at attractive valuations, a capable manager can take a business growing at 5% p.a. and generate double digit shareholder returns through shrewd allocation of excess cash flows.
In conclusion, sometimes the jockey can generate more value than the horse. If you find a very stable company, with sticky/recurring revenues and a manager with a history of profitable capital allocation, the organic growth rate of the business/industry is less important. Indications of good capital allocation include:
- Buying-back their own stock when the share price is undervalued
- a PE less than 10x will generate double digit returns
- Making acquisitions when the market values the company on a higher multiple than the price required to transact in the private market