Defensive Value Investing: A 20-week course
“Each company selected should be large, prominent, and conservatively financed. Indefinite as these adjectives must be, their general sense is clear.”Benjamin Graham
Companies are essentially a collection of assets, such as factories, equipment or cash in the bank, which are deployed in the pursuit of a common goal (either social, financial or a combination of both).
Last week we looked at profitability, i.e. the returns generated by a company on its sales and assets. This week we’re going to look at how those assets have been paid for, because that can have a dramatic impact on riskiness of their returns.
Here’s an example of how risk is affected by a company’s funding arrangements:
The lesson from this example is that things are going well, debt financing can boost returns; but when events take a turn for the worse, too much debt can amplify even minor declines in profits and quickly turn them into losses.
And it gets worse.
In that example, if the company didn’t have the cash to pay the interest in full, the bank may be able to ask for the entire £ 1m loan back immediately. That would mean either having to sell the factory in a hurry (and probably at a price far below the original £ 1m), or the company could ask shareholders for additional equity funds via a rights issue to pay back the debt.
Neither outcome is likely to be welcomed by shareholders.
That’s not to say that having no debt is always the best option. There is a sweet spot between having no debt, which is safer but reduces profits, and having too much debt, where profits are boosted but only by taking excessive risk.
This week we’ll cover some methods for finding companies which appear to be operating in that sweet spot.
For the sort of relatively defensive and successful companies I’m interested in, the meaning of conservative financing basically comes down to the amount of money the company has borrowed.
And not just how much it’s borrowed, but how much compared to its ability to repay those borrowings in good times and bad.
There are lots of different ways to examine this. Two of the most popular are interest cover and the net debt to EBITDA ratio:
Personally I don’t use either of these methods because they rely on earnings from a single year, typically the most recent year. I think it makes more sense to compare debt or interest to a company’s average earnings over a number of years, because earnings in a single year are volatile and unreliable.
Using average earnings should produce a ratio which is more reliable and robust than one which depends on the earnings of a single year.
I also prefer to use profit after tax rather than EBIT or EBITDA. Post-tax profit is also post-interest, so companies that have large debts, or which pay high interest rates on borrowed money, will have lower post-tax profits than otherwise. Any debt ratio based on post-tax profits will look even worse for these companies and that’s exactly what I want.
Taking those ideas into account, I prefer to look at the ratio of total borrowings to ten-year average net profits. Rather predictably, I call this a company’s debt ratio.
I do have a rule of thumb associated with the debt ratio, but the exact amount of debt I’ll allow depends on whether the company operates in a cyclical or defensive market.
Differences between cyclical and defensive markets
In simple terms, cyclical markets have cycles of boom and bust while defensive markets don’t, or at least they experience these cycles to a much smaller extent. During cyclical booms, companies operating in these markets often see their profits grow rapidly and consistently for a number of years. However, when boom turns to bust these cyclical profits can shrink dramatically and losses are not uncommon.
Because cyclical company profits are typically more volatile and more uncertain, I have a lower debt ceiling for those companies than I do for their more defensive and predictable cousins.
Given this difference, the first step in analysing a company’s debt burden is to decide whether it operates in a cyclical or defensive market.
Deciding whether a company is defensive or cyclical
Markets can be defined at many levels. You could describe a company as operating in the retail market, but if you wanted to be more specific you might say it’s a food and drug retailer.
The Industry Classification Benchmark (ICB) defines standardised terms for various markets in a hierarchical structure. For example, Retail is a super-sector and Food & Drug Retailers is a sector.
We’re going to use the ICB sector definitions because they’re widely used by data providers and you can find them on the London Stock Exchange website. You can also see a company’s sector on the UK Value Investor stock screen.
Just as importantly, each sector has been defined as cyclical or defensive in the UK Dividend Monitor, a quarterly newsletter outlining dividend developments in the UK market. This makes it easy to work out whether a company is cyclical or defensive, at least according to its sector.
You can see the list of sectors in Table 4.1, and I’ve highlighted (in bold) a handful of sectors which I define as highly cyclical.
|Aerospace & Defense||Automobiles & Parts|
|Fixed Line Telecommunications||Construction & Materials|
|Food & Drug Retailers||Electronic & Electrical Equipment|
|Food Producers||Financial Services|
|Gas, Water & Multiutilities||Forestry & Paper|
|Health Care Equipment & Services||General Industrials|
|Mobile Telecommunications||General Retailers|
|Nonlife Insurance||Household Goods & Home Construction|
|Personal Goods||Industrial Engineering|
|Pharmaceuticals & Biotechnology||Industrial Metals & Mining|
|Oil & Gas Producers|
|Oil Equipment, Services & Distribution|
|Real Estate Investment & Services|
|Software & Computer Services|
|Technology Hardware & Equipment|
|Travel & Leisure|
Table 4.1: Defensive and cyclical sectors as defined in the UK Dividend Monitor
For most companies their assigned sector definition is accurate, but in some cases judgment is required when a company doesn’t neatly fit into the ICB system.
For example, Reckitt Benckiser is a seller of defensive products like soap and detergent (they’re defensive because people keep buying soap even during recessions), but it’s listed in the cyclical Household Goods & Home Construction. In my opinion Reckitt Benckiser should probably be in the defensive Personal Goods sector along with companies like Unilever.
If you run into this sort of mismatch, just make a note of your opinion on whether the company is cyclical or defensive.
Calculating the debt ratio
We now have all the components which go into the debt ratio. These are:
- Total borrowings – Made up of short and long-term interest-bearing debts. You’ll find these on the balance sheet under current and non-current liabilities respectively.
- Post-tax profits – Going back ten years. You’ll find these on the income statement.
- Cyclicality – Based on the company’s ICB sector and Table 4.1. You can find a company’s sector on the London Stock Exchange or from data providers such as SharePad or Morningstar.
The steps for calculating the debt ratio are:
Steps for calculating the debt ratio
Having calculated the debt ratio, we can then apply one of the following rules of thumb:
Rules of thumb
These rules of thumb are not drawn out of thin air.
The limit of five for defensive companies is based on a rule of thumb that Warren Buffett has apparently used in the past. His rule, according to Mary Buffett in her book The New Buffettology, was to look for long-term borrowings to be less than five-times average post-tax profits.
The lower limits for cyclical and highly cyclical sector companies is a more cautious version of the same rule and is based on my own hard-won experience.
Calculating the debt ratio is relatively simple so let’s run through the process using some of my recent holdings.
Telecom plus’s debt ratio
Telecom plus is one of the UK’s leading utility challenger brands. It operates as The Utility Warehouse and offers customers gas, electricity, telecoms and broadband services with the simplicity of a single bill.
It’s listed in the defensive Fixed Line Telecommunications sector, and I think that’s reasonable given the defensive nature of its products (most people will keep paying their phone and electricity bills in a recession).
As a defensive company, Telecom plus should ideally have a debt ratio of less than five, otherwise I probably wouldn’t consider its debts as conservative unless there were exceptional mitigating reasons.
To calculate the debt ratio we need the company’s profit after tax for the last ten years, which is shown in Table 4.2.
|Year||Post-tax Profit (£m)|
Table 4.2: Telecom plus’s profit after tax for the ten years to 2018
We’ll also need the company’s 2018 current and non-current borrowings, which are zero and £39.4m respectively.
And here’s the calculation:
Calculating Telecom plus’s debt ratio
Telecom plus’s 2018 debt ratio is a relatively low 1.6. That’s far below my maximum of five for defensive sector companies, so at this stage it seems that Telecom plus has conservative levels of debt.
WPP’s debt ratio
WPP is the world’s leading marketing company. It’s a member of the FTSE 100 and is listed in the cyclical Media sector. As a cyclical sector company I expect it to have debts that are no more than four-times its ten-year average profits.
Table 4.3 shows WPP’s profit after tax for the ten years to 2018. In 2018 it had current borrowings of £1025.1m and non-current borrowings of £5634.8m.
|Year||Post-tax Profit (£m)|
Table 4.3: WPP’s post-tax profit for the ten years to 2018
The steps to calculate WPP’s debt ratio are:
Calculating WPP’s debt ratio
With a debt ratio of 6.5, WPP is carrying an amount of debt that I would not consider conservative for a cyclical sector company. However, I’m not a mechanical investor and that’s why I have rules of thumb rather than strict rules.
So having looked at WPP in some detail during early 2019, I decided to invest despite its somewhat excessive debts.
Why would I do that?
The reason is that WPP’s management had recognised that its debts were excessive and a plan to reduce them was already in place. Given its attractive qualities (including steady growth, good profitability and a 7% dividend yield) and clear plan to reduce debts, I was happy to invest even though on paper its debts were too high.
This is a good example of how investing can be, and probably should be, more than just a number crunching exercise.
Next week we’ll begin to think about whether or not a company’s shares are good value for money. We’ll do this by comparing a company’s current share price against its past earnings and dividends.
But first, here’s a summary of the conservative debt rules of thumb.
Rules of thumb for conservative debts