investing in a tortoise

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:

  1. Return the capital to shareholders via a share buy-back or dividends
  2. Pay down outstanding debt
  3. 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:

Assumptions

  • 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

IRR:           16%

deleverage.PNG

 

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

IRR:                    23%

 

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:

Capital allocation analysis

 

Share buy-backs

buyback.PNG

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.

 

Acquisitions

acquisitions

 

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

 

 

2 thoughts on “investing in a tortoise

  1. I am really enjoying your posts, keep it up. I found this one particularly interesting as I have an investment in a similar situation. The maths makes sense and I agree with the paying down of debt adding value to the equity. However I do have two questions/thoughts:

    Does this logic still apply if the debt has zero cost?

    Using the above example, $35m mcap and $40m debt, I imagine the equity would revalue partly because the debt becomes less risky/ psychologically threatening (as it is quite high), but also because it would result in a significant increase to FCF due to lower interest payments. However, it’s hard to see that revaluation happening if the debt has zero or close to zero cost, because there’s no real return on the cash that you contribute to debt repayment. So I think that interest rates must be a key determinant there. I guess I’m just not sure why the equity part of the EV has to rise simply because debt is going down. What’s to stop the EV decreasing instead?

    On a related note, do you think it is a linear relationship?

    For example does the first $20m reduction in debt lead directly to a $20m increase in the EV? Is it the same at $25m / $25m? Thinking about it a bit I’m not sure whether I would expect the benefits of lower debt to be skewed closer to the ‘front end’ of the repayments (e.g. when debt goes from $40m to $30m) or the tail end when debt gets repaid entirely. Not sure on that one, just thinking out loud.

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    1. Thanks for the kind words 10footinvestor.

      On your first point, the cost of the debt is irrelevant in terms of the value transfer from holders of the debt to common equity holders. The caveat here is that the EV/EBITDA multiple you originally purchase the business on is “fair”. Therefore, if the multiple is fair and stays constant, and the EBITDA stays constant, the market cap must increase to offset the decline in debt, regardless of the cost. Otherwise, the multiple will decrease despite the lowered business risk, which is irrational – but it can happen.

      On the second point, continuing my rationale from above, I would have to argue the relationship should be linear. Otherwise, the multiple will come down and down until some arbitrary amount of debt is paid off and the multiple increases back to the original.

      It’s worth noting that in a sense, this is all academic, because markets can/are irrational at times. The point I’m trying to make is that if you can find a stable cash flow business, with too much leverage, that is paying down the debt and purchase it at the right price, eventually the market should reflect this value transfer and you should achieve the theoretical IRR you calculate at the start. When this happens is anyone’s guess – it’s like asking when you expect an undervalued business to increase in price and eliminate the anomaly.

      Hope this helps,
      Dan

      Like

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