Transcript
Hello, and welcome to the Download. I'm your host, Dave Richardson, and it is Stu’s days. And I think summer Stu’s days are my favorite Stu’s days of the year. Seasonally adjusted, I think they're the best.
I think any Stu’s day is a good day, Dave. I don't know about you.
Well, this Stu’s day is going to be particularly exciting because we're launching a new feature series off the popularity of you as an educator around markets and investing. We're starting today's first episode of Stuniversity. So today in Stuniversity, it is «Balance sheet 101». And we're going to look at various sectors and the way that you look at these companies and their balance sheet, the flexibility they have in their balance sheet, how they manage their balance sheet, the impact of that in a rising interest rate environment, and the different phases of interest rates rising. We know that many of our regular listeners have been listening to the previous Stu’s days podcasts. If you have listened to all the previous episodes, you have an automatic prerequisite into today's lesson at Stuniversity. If you have not listened to the previous podcasts, you need to go back and listen, or at the very least, subscribe, or leave us a five-star review. You can give me one star, but you got to give Stu five, because he's really the star of the show and I can't afford to lose him. And he's fragile.
It's funny when you say Stuniversity, because we have two Stuniversity students with us for the summer. When I was starting off, I had to prepare what they call comp tables. A bunch of companies and they're comparable financial statistics that the executives would take off to their meetings. And I was in real estate at the time, doing a rotation. So I had to do this comp table that had enterprise value on it. One of the people came back from their meeting and turned out to be a great executive for the bank. He came and asked me: what is the enterprise value? I looked at him and he was like, you don't know what enterprise value is, but you filled in this comp table? And I was like, you're pretty much right. He was very kind and gave me the quick and dirty on what enterprise value was, which was the market cap of the company; all the shares outstanding times the share price, plus all the debt on the balance sheet. And it was a lesson. It's simple math, but it was a good lesson because the balance sheet matters, particularly in real estate. But debt and the cost of debt is something that equity holders need to really think through. So I had to fill in these enterprise value statistics when I was starting in the business. And I asked the two summer students we have in Stuniversity what enterprise value is and to go figure it out. Which brings us to today's topic of interest rates. We talked about rising interest rates; we talked about peaking interest rates. But as an equity investor, we need to think through that on a number of levels because businesses have debt almost in perpetuity. Some businesses, like banks, make their living based on interest rates. Others use that capital because it's a little bit cheaper than equity. It comes with guarantees. But how you structure your balance sheet, the amount of interest that you pay will have an impact on the amount of cash flow that that business generates.
And this is something that you pay a lot of attention to. Is there any sector in particular where you pay more attention to this than others? Or is this across the board? You've got to have a very good understanding of a balance sheet before you'd invest in something?
Well, it is across the board because almost every business uses debt to some degree. We do have a handful of businesses that don't have debt, and for those, you don't have to worry about, because the enterprise value is just the market capitalization. And those businesses are often quite cash generative. But in general, the first thing that happens, when you do enterprise value, you divide it by a proxy for cash flow, which we would call EBITDA, which is earnings before interest, taxes, depreciation and amortization. You would take the enterprise value and you divide it by the EBITDA and that gives you, generally speaking, how much cash is available on an unleavered basis to pay both the equity and the debt side of the balance sheet. The first thing that happens as interest rates rise is, when we talk about valuations compressing, if a stock goes from ten times to nine times EBITDA, if it has no leverage, then the value of the equity has gone down 10%. Because the ten is all equity, so it goes from ten to nine, goes down 10%. If it happened to be levered seven times its EBITDA and it goes from ten to nine, then the equity goes from three to two. You got a much larger change, even though the enterprise value of both those businesses only declined by 10%. How much debt they have on the balance sheet will impact the share prices in the stock market. One goes down 10%, the other one might go down 50%, just because of the balance sheet. So right off the top, before you even get into how is this going to flow through the income and cash flow statement over time, you need to be aware of how much debt there is. The reason that banks trade at 9, 10, 11 times earnings, and people say, well, why don't they trade where the stock market trades at, say 15, 16, 17 times earnings, is because banks balance sheets are massive. They use a lot of leverage, and they use it extremely well and they're regulated and that's an important feature. But the assets on the balance sheet are multiples of the equity. So we have to think about it, how it's going to affect valuation as rates are changing. And then we need to think about it how it will impact cash flows over time. A bank, as rates rise, don't pass them on first in deposit costs. The loans reprice, then they start passing them on deposit costs. But banks also often have securities portfolios that have duration of a certain period of time and eventually those start to renew and those renew at higher prices. So the net interest margin can almost look like an S curve, sometimes. It rises, then it stabilizes or falls a little bit and then it has one more push upwards over time. A utility company, something like we turn on the power in our house or what have you, that's called a utility company. The government allows them to earn a certain return on equity and they allow them to use so much debt. So when the interest costs rise on their debt, they're allowed to pass it through to the end customer. So for those companies, you worry about it, but long term you're not as worried because you know they'll get it back. Other companies, like some real estate companies and things like this, where you have higher interest rates and they've termed out their debt, so maybe their debt doesn't mature for five years, you have to sit there and say, well, in five years, what will they have to pay and will rent have grown enough to cover off that additional expense. When we look through all sorts of businesses, one of the things that we often look at is what they call debt to EBITDA. You take the amount of debt that the business has and you divide it by that EBITDA, and if it's a high number, then you worry about what happens when interest rates rise or how could the valuation change if we get a small change in the enterprise value and you have that much debt. Those are just some of the things off the top of my head as we think about this environment where revenue, revenue growth in particular, is a little bit tougher to come by, and the employers and employees want more. The government likely wants some more on taxes. And capital. The provider of fixed income, the provider of loans, they want some more. We have to think through each one of those categories. And for many of the companies we own, you really need to think through that balance sheet.
If I was looking at a consumer products firm or a technology firm, how would this play in and how would it look different from these more traditional firms that you just walked us through; banks, utilities, etc.?
You look at a couple of things. Normally there's less leverage. Debt to EBITDA might be one to two times, so not very high in the grand scheme of things. And these businesses are very cash generative. And if I was a consumer products company, when there is some inflation, I'm able to raise my prices too. I have higher prices, I maintain my margins, I have more cash flow. So even though my debt costs me some more, I've reaped some more cash flow. So what we talk to when we have these long-term discussions with management, what we're looking for them to do is to set what we call a capital structure through the cycle. So regardless of what interest rates are, they're setting a capital structure that they think the business can withstand through low interest rate, high interest rate, that type of thing.
Out of these different ratios that we've talked about, is there one that is your favorite? Is there a different one for each industry that is most important to you? Or again, like most things, are they simply data points, one of a number of different data points that you're using? Or is there in a particular industry where that one ratio is the key ratio in terms of the way you think about the business?
Well, a bank is kind of unique. Inside a bank, we look at capital ratios and we look at liquidity ratios. Outside of a bank, I think that the EBITDA would be the one that you would really focus the most on. And the reason you do that is like the old Warren Buffett quote about cash: when it's plentiful, you don't think about it. It's like oxygen. But if you need it, it's the only thing on your mind. We don't want to have too much exposure to businesses that get into those types of pinch-like situations. And if we are in those situations, we want to enter them when we want to provide the additional capital that they might need so that we earn great returns as they repair their balance sheet. So quite often what changes through the cycle is business quality is usually quite stable. Balance sheets sometimes get a little bit over their skis. So when you can come into a situation and you can be the capital that fixes the balance sheet of an otherwise quality business, that's usually a pretty phenomenal spot to be as an investor.
Do those opportunities come up a lot for you? Is this something that a typical investor would be able to find, opportunities to do on their own? Or is this one where you're investing at scale and your ability to scan across the market gives you the potential to be involved in these types of distressed companies or companies that are strong but need a little bit of a lift at a particular point in time?
Normally, during this period of the cycle is when you get those opportunities. We talked a couple of weeks ago, one of the early cycle businesses that emerge is capital markets. So there's two things that take place as the economy finally finds a level that both sides agree is going to persist for some time. If I'm the seller of a business, I want you to pay me for my best cash flow. So I say that the economy is going to be great and that's what you should pay me on. And if I'm a buyer of a business, I say, oh, no, things are really bad, I got to pay you on the cash flow that you'll generate in that environment. If you have a well-capitalized business, those things don't trade because the seller doesn't need to and the buyer is not going to pay up. So the first thing you need when you get M&A is people to agree on what the environment is going to be so that you are both agreeing on the cash flow the business will produce and you can come to conclusion on valuation. The second thing that also takes place during this environment is often a reflexiveness to providing loans. And when things tighten a little bit, everyone says, I used to do a loan to value, or I used to do debt to EBITDA of three or whatever the number might be. And your EBITDA is a little bit lower, so I'd like you to have a little bit less debt. You need to go find some equity and then normally, if you can provide that type of equity, the business then goes back to normal. Then someone comes along and says, well, we give you a little bit more capital. It's the reflexiveness of it all. So during this phase of the environment, this is often when you get some of those interesting situations.
But again, these are opportunities that you're able to take advantage of because you're investing billions of dollars. Me with my couple of hundred bucks is not going to be particularly helpful to a company that's trying to raise a lot of capital in a short period of time because they've got a specific need for that capital.
At the company level, that's correct. But it's very akin to knowing your local real estate market. That piece of property, if it had no debt on it, I just know it's worth X, but because it has some debt on it, it's come down in value. So if I can go in and I can remove the debt, so all of a sudden it's not distressed and the value can float back to what it would otherwise be worth, I can capture that spread. So the reason to run full circle on the enterprise value calculation, the reason you want to run those calculations is because if you have a low enterprise value to EBITDA, as an investor, you can say, well, even if it had no debt, if I paid 100% equity, I'm getting this multiple. And that's a lower multiple than that business would normally trade at. It's looking at a business and saying what do we think it's worth if the capital structure was correct? And do we think that there's a difference in those two values and if we can solve for that, we can make some good money.
I really love that analogy about knowing housing in your neighborhood. It's funny, I'm walking the dogs the other day and I run into one of my neighbors who I hadn't talked to in quite some time. But I see him out there, he's always walking his dog around. And we ended up talking for about an hour. And he basically knew what was going on in every house in our neighborhood. So the couple that are being torn down and rebuilt. He gave me all the details, what's going on with city government. And this is this discussion which we should probably get into sometime about investing in real estate versus stocks, because people invest and think about real estate in a much better and more consistent way than they think about investing in stocks and bonds. A little bit of a pet peeve of mine. This idea that I know because I have a feeling I'm there, I'm immersed in it every single day and I'm immersed financially and emotionally in that area every day. I track and I have a sense and a feel for what's going on in the area. And then to take the stock market and think of the thousands of companies that you need to think about across the stock market, do you ever get as comfortable as you do understanding your own neighborhood when it comes to housing? I would suggest, for most investors they never get there. If this analogy doesn't prove it, just listen to the first ten minutes of this particular podcast and go back, and the analysis and the expertise and understanding you need to have to be really successful buying individual stocks versus finding someone that you can rely on to make those decisions for you. Which is what happens when you buy an investment fund and hire an investment manager such as yourself. But I'd never really heard a position that way. It just struck a chord with me. Because I know my neighborhood. I walk around and I should know my neighborhood and that gives me a degree of expertise there— not even in the broader real estate market, but in my neighborhood. And so that's where, again, you spread it across an entire stock market. It's pretty hard to understand that maybe there's a particular niche that you might understand, but to understand it more broadly is a very difficult thing to do if you've got a life outside investing.
Yeah, there's 30 people on our team, and the role of each of those 30 people is to know some neighborhood of stocks, as well as the guy you just talked about walking his dog knows your neighborhood.
But again, each of those individuals is working on that full time and has worked for a number of years developing that level of expertise, which, again, for any one individual trying to invest, would be a very difficult thing to do.
In your life, you might know 30 or 40 stocks really well. You might know a lot pretty well, but 30 or 40 stocks at that level would be quite something.
And even you layer in the technology, and you add that element to it. Your student doesn't need to go and do that calculation on a spreadsheet; a computer does it for you. But there's still an art on top of the science of really understanding what's going on there and understanding that value.
Well, no question, because once you see the statistic, then you're reminded that when you make a purchase, you're just buying a set of assumptions. So then all the work starts on understanding those assumptions. But the initial statistics sticking out at you is often a pretty good starting point.
Wow, we got to a great spot here, Stu. A lot of great learnings in the core content of Stuniversity. And then, of course, we've been able to bring it to real life. Ultimately, our objective, every time we do one of these, is to educate and learn because we are all students at Stuniversity, on Stu’s days. But we'll warn everybody we're about to do a little bit of a summer break. We'll probably get down on the frequency over the next six to eight weeks as we take some time and people pay less attention to these types of things. So we'll just give you that warning up front. But this was a great primer and a little extended version of Stu's days to get people thinking for when we return to class at Stuniversity in the fall. So, Stu, thanks for this. We'll still do some regular podcasts, but you and your family have a great summer and we'll talk to you over the next couple of weeks.
Great. Thanks very much, Dave. And you have a great summer as well.