First published in the Financial Times on 18th September 2012.
Do your homework and trust history and cash rather more than spreadsheets
For any investor there is only one quest that matters: the search for value. But knowing which assets are genuinely cheap is very difficult; this intellectual challenge explains why so few market professionals are consistently successful.
Perhaps the most subjective aspect in analysing any business is the quality of earnings. By this I mean not so much whether the accounts are accurate and conservatively stated, but whether the earnings are repeatable and bankable. Many enterprises have an unsustainable model, only temporary advantages, rising competition and weak fundamentals. They should, all other things being equal, trade for a low multiple.
By contrast, some companies have high forward visibility of revenue, defendable and attractive margins, a strong franchise with high barriers to entry, proprietary technology or brands, and a sizeable market share. Such rare and enviable situations are usually very expensive to purchase.
As savvy entrepreneurs know, there is a world of difference between accounting profits and cash profits. Cash flow matters much more than almost anything in a company. This is the money left over every year after tax, interest, capital expenditure and all outgoings have been settled – the retained earnings. It is the hidden difference between shares and bonds.
The equity holders of a company enjoy the residual profits after all other claims, such as interest and dividends, are paid. Over time, this should lead to growth in net worth, whereas the principal of a bond never grows.
For many years investors have obsessed about growth and neglected to consider underlying cash generation. Yet it is possible to make solid and safe returns by owning mundane companies that barely increase their revenue or bottom line each year, but are effective at converting profits into cash. These types of businesses can often be bought on modest multiples of perhaps four or five times.
Another advantage of cash generators is that they can be partially acquired using debt, since a bank will feel secure enough to lend against them. In an era of low interest rates and generally weak returns, companies that can deliver net cash every year should attract more buyers. By contrast, growth companies ought to be regarded with greater suspicion in a stagnant economy. Moreover, growth usually takes working capital – meaning a reduced cash surplus for distribution.
An example of how markets despise a business they label as ex-growth is Home Retail Group. This is the £5.5bn turnover retailer that owns Argos and Homebase among other high street brands. It has net cash and sits on an ebitda to enterprise value ratio of just 2.5 times – in a year when profits are depressed. Clearly, institutions see it as mature and probably in decline.
Yet for sexy retail stories, private equity will pay as much as eight or even 10 times. This huge pricing discrepancy seems irrational and hard to justify. So many investors are seduced by exciting projections and bored by reliability and history.
Private equity pros added back depreciation and used leverage to enable them to buy unloved companies from quoted investors. But now the ebitda multiples paid by private equity shops are sometimes higher than the price/earnings multiples at which sensible, publicly listed companies trade. Has all the dry powder commanded by the private equity shops distorted their judgment? Why would listed companies be cheaper than private ones?
Perhaps it is the sheer weight of money chasing those scarce companies that appears to deliver growth. Or perhaps it is the habit of buying and selling businesses between private equity firms – possibly creating a closed universe with no sense check on value.
Most of us are guilty of getting overexcited at new prospects, forgetting all the possible pitfalls contained in every opportunity.
And due diligence will only reveal so much – I have spent hundreds of thousands of pounds on advisers, only to discover after the event that they missed critical issues. And I was recently reminded that when we backed Topps Tiles, one of our better bets, we commissioned no financial analysis.
Perhaps the only rules when buying companies are to do your own homework, and trust history and cash rather more than spreadsheets showing a buoyant future. Ultimately, financial models are less important than common sense.