Most people would agree that any investment proposition must involve some consideration of risk and return. A good investment idea is one that sees an attractive return profile without commensurate downside risks.
In my experience, most equity investors tend to start with the return side of the equation because there is a natural bias towards looking for the upside. However it is also possible to start with risk by investigating the things that can go wrong for a company and how this might impact the valuation. Investment opportunities may present themselves when market expectations as to the extent and likelihood of risks materialising are out of line with the true fundamental risks.
To illustrate this, I will consider financial risk and then examine an example1.
The problem with financial risk is it tends to be most dangerous when it is least obvious. In the years before the financial crisis of 2008, I vividly remember companies with low financial risk trading at a discount to those with high financial risk. The cause of this perverse situation was the “efficient balance sheet” mantra which led to many companies taking on far too much debt in the belief that this would drive higher earnings and higher equity valuations. When the downturn came, the materialisation of this lurking financial risk led to huge losses for investors in over geared companies. In contrast financial risk can be a lot less of a worry when it is blindingly obvious. If there is already widespread awareness and fear of financial risks, it is far more likely (although not certain) that this will be discounted into share prices.
I find the stock market often takes a simplistic view of financial risk but reality can be more nuanced. What matters is the probability of an observed financial risk actually materialising. Simple rules such as “net debt / EBTIDA ratio greater than 2.5x is high risk” often miss the point. Some business models can easily support this level of gearing if they are cash generative and relatively defensive. On the other hand a highly cyclical capital intensive business model is more likely to get into trouble with this level of gearing.
Even banking covenant breaches are often not the disaster many think they are. A sustainable cash generative business model with strong earnings cover of interest payments and lots of liquidity is highly likely to secure an amendment or waiver of banking covenants if the company faces temporary issues. The problems tend to arise as a result of liquidity or solvency issues where the company cannot pay its debts or if there are genuine doubts as to the fundamental value of the business.
I am not suggesting investors should actively seek out financial risk, but I do think the stock market often mis-prices financial risk. Moreover, I have noticed many more such situations appear amidst the market volatility of the past six months.
One example is Equiniti Group, a fairly recent IPO.
Equiniti provides outsourced financial services to many of the UK’s leading listed corporates. Their services include managing share registrars, provision of employee share schemes and the administration of complex public sector pension schemes. The end markets are mostly oligopolistic with Equiniti enjoying high and stable market shares underpinned by well invested technology platforms. Customer churn rates are typically minimal due to the relatively low cost of the service and its critical nature. As a result profitability tends to be high and reasonably predictable.
Because of these factors, one would expect the stock market to put a high valuation on a company like Equiniti. Yet today the shares are valued on a p/e ratio of 10x, a low absolute valuation and a significant discount to the market and the company’s peers such as Capita. I believe a key reason for this low valuation is a perception that Equiniti’s financial risk is too high.
For the year ended 2015, Equiniti reported £86m of EBITDA with £246m of net debt – a 2.8x leverage ratio2. For 2016, if Equiniti trades in line with analyst forecasts, EBITDA will rise to £93m, net debt will fall to £230m and the leverage ratio will fall to 2.5x3.
In the current volatile market environment, a leverage ratio above 2.5x is regarded by many as being too high. But is this really the case for Equiniti? The company generates prodigious cash flow which means it can deleverage relatively quickly if management wanted to. Moreover, the interest cover is over 6x. Profitability would have to collapse before the company came anywhere near not being able to pay its debts. And the risk of rising interest rates is mitigated to some extent by the fact that Equiniti holds large cash balances on behalf of its customers on which it is entitled to earn interest, but currently receives very little due to the low interest rate environment.
These factors mean the risk-return profile for Equiniti shares is, in my opinion, very attractive. If Equiniti can simply trade as normal, I would expect the shares to perform very well as the earnings continue to grow, the debt and leverage comes down, and the valuation rating rises. I believe this opportunity exists due to a mis-pricing of Equiniti’s financial risk.
1. This is no recommendation to buy or sell any particular security
2. Source: company reports
3. Source: Bloomberg, AGI estimates