By James Henderson
While balance sheet discipline is often a welcome feature of a potential investment, occasionally it pays to consider businesses that are spending cash on themselves, as we have done for Lowland Investment Company.
Listen to any fund manager presentation and the core script will almost invariably include lines like this: “We buy strong, growing companies that are generating lots of cash and have strong balance sheets and barriers to competition… Blah, blah…”
Well, perhaps not “Blah, blah…” – but you get the gist. It would be nice to hear a manager say that sometimes they include in their portfolio companies burning cash so fast that without an urgent injection of capital they face ruin.
You might ask why on earth anyone would want such a company, but many of the best investments I have ever made have fallen into this category. One of our best performers this year has been Rolls-Royce, which is up 140% so far.
This is a company that in January was described by its new boss as a “burning platform”. Tufan Erginbilgic pointed to the disappointing returns made on invested capital and set about changing things.
He has sold off non-core businesses – one of the largest being the €1.8bn disposal of Spanish joint venture ITP Aero. He has focused spending on priority areas and renegotiated maintenance contracts.
Post-Covid recovery in air transport has helped. The combination means that in just the first six months of the year operating margins soared from 3.4% to 12.4% and the company generated twice as much profit as analysts were expecting – £673m.
Those earlier analyst forecasts have shown how a gloomy mindset can set in around a company. Rolls-Royce was certainly not one for investors who only like companies with attractive cash flows. They have missed out.
Unearthing these opportunities takes research. Often you are looking for yesterday’s leaders in recovery, like Rolls-Royce. But more usually you find them in smaller companies. When investing in these businesses you must always be aware that at some point you may be touched for more cash – or see your shares diluted. It is called a “rights issue”.
It is easy to forget that the purpose of the stock exchange is to help companies raise capital. In return they offer a stake in the business and a share of all future profits for as long as the company operates and those shares are in operation.
Companies can seek to raise cash for all sorts of reasons. In the AIM market it would usually be to build new plant, expand production or take a new product from prototype to production. Examples in our portfolio include alternative energy companies such as AFC, ITM and Ceres. These are still fairly early-stage businesses but could have enormous potential as we move to a low-carbon world.
Sometimes companies can experience a cash squeeze because of events, like Covid. For investors who support any fund-raising endeavours the hope may be that if the business can get through to the other side of the crisis it will find competition weakened and gain significant market share.
One of the most memorable examples of a company raising capital because of a crisis was in 2001. Following the terrorist attack on the Twin Towers in New York, insurer Hiscox came to the market twice – in 2001 and 2002 – seeking around £164m. We backed it. With that money it was able to write new business at an attractive rates, because many of its competitors were out of the market in light of their own cash struggles. It helped enable Hiscox, then a relatively small business, to step into the big leagues. The rights issue shares were £1.20 and £1.65. Today Hiscox shares trade at more than £10.
There is heightened risk in cash burning investments, but risks can be mitigated. We want to understand clearly what is behind the cash burn and how quickly investment might be expected to pay off. Is it a Covid-style crisis and a story of the fittest survivor thriving when normal service resumes?
A crucial question we ask ourselves is how much we trust management. Often new management will launch a rights issue as part of a big reorganisation plan. Does that plan excite us? Can we see the potential or is it pouring good money after bad?
It might be that the plan is not articulated well and is not convincing. It might be that we do not have confidence in management’s ability to execute it. In such cases we may not just decline to pay up – we may sell our shares altogether. Sometimes it is better to take your losses and move on, putting your money to work in more promising areas.
Of course, we have had failures, but when you get the decision right the rewards from a cash burner can far outpace those offered by the majority of healthy cash generators that can form the core of portfolios.
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Glossary
Balance sheet
A financial statement that summarises a company’s assets, liabilities and shareholders’ equity at a particular point in time. Each segment gives investors an idea as to what the company owns and owes, as well as the amount invested by shareholders. It is called a balance sheet because of the accounting equation: assets = liabilities + shareholders’ equity.
Barriers to entry
Factors that can prevent or hinder new competitors from entering into an industry or business area, such as high start-up costs, patents, technical knowledge, brand loyalty etc.
Capital
When referring to a portfolio, the capital reflects the net asset value of a fund. More broadly, it can be used to refer to the financial value of an amount invested in a company or an investment portfolio.
Free cash flow (FCF)
Cash that a company generates after allowing for day-to-day running expenses and capital expenditure. It can then use the cash to make purchases, pay dividends or reduce debt.