Competing for assets

Rule 6: Competing for assets

A company’s shareholders do not own it. They own its equity. This is an important distinction that is critical when it comes to the question of how your investment is going to pay back.

One of the favourite jargon words of managers of quoted companies is that everyone is a “stakeholder”. However warm this sounds, equity investors should be aware of two points. The first is that, legally, they are third rate stakeholders and that other creditors of a business are not only their superiors but also, potentially, their enemies. Secondly, depending on the nature of the business and the greed of the management, shareholders, employees and managers can be in direct competition for any “added value” that the company generates.

When you buy shares you are not buying part of the company. You are buying part of the equity. This is why the price of a company’s shares often dramatically exaggerates a change in the perceived value of its underlying business.

For an investor, the most useful measure of a company’s size is its enterprise value. Enterprise value is market capitalisation (the number of shares issued multiplied by the share price) plus net debt (financial liabilities minus financial assets). If the company’s financial assets exceed its financial liabilities it is said to have “net cash” and the enterprise value is market capitalisation minus net cash.

When most of a company’s enterprise value consists of net debt, there is much to play for from a shareholder’s perspective. This is best shown with a live example.

As I write I own shares in Enterprise Inns. This is a pub operator that expanded too enthusiastically and became dangerously indebted. Leasing pubs to landlords who want to run them is fundamentally a very profitable business. Enterprise typically makes operating margins of 45%+ which is about as good as it gets (Apple’s operating margin is 36.5%, for instance.) To the banks, Enterprise must have looked like a cash generating machine that was close to a licenced printer of money. Probably the Enterprise management felt the same way. Consequently the business borrowed and borrowed and expanded its pub empire.

Naturally, when recession hit and pub customers and landlords started to suffer, Enterprise was left with a declining business trying to support a balance sheet designed for growth. At such times such as this, the creditors, who always have one motivation only – to be repaid – become very worried and will foreclose – probably making the equity worthless – if it suits their purpose.

Enterprise is crawling up the road to recovery but it’s a long road. In the last three years it has reduced its debt by c.£1bn, which is around 25%. Yet it remains a very indebted company. At today’s share price (67p) the enterprise value of Enterprise Inns is c.£3.19bn of which net debt is £2.86bn and equity (the market capitalisation) just £0.33bn. So the enterprise value is 9 parts debt to 1 part equity.

If the value of the business falls by 10% and the debt remains constant, the shares will be effectively worthless. That is the risk of investing in Enterprise Inns now and the potential penalty if the progress along the road to recovery falters.

But let’s skip quickly to the upside. Let us say that the business marks time but further progress is made in reducing debt through cash flow and, perhaps, some disposal of zombie assets. The enterprise value of the company sticks at £3.19bn but net debt is cut by another 10% to £2.57bn. In this case, the value of the equity rises from £0.33bn to £0.62bn. That makes 123p per share or a rise of 83% without the overall value of the business having changed.

All an investor has to do is to decide whether today’s share price (67p) is a fair reflection of the various possible outcomes.

Ultimately we all have to decide for ourselves using whatever evidence, anecdotal or otherwise, is available to us. I strongly recommend doing as I did in the example of Enterprise: check the group’s operating profit margins. Famous names and big brands often operate in very mature and competitive markets e.g. Unilever, regarded as almost the last word in investor safety, makes operating margins of c.15%, Marks & Spencer makes around 8% and J Sainsbury c.4%. On that basis, the fact that Ladbrokes the bookmaker consistently achieves an operating margin of c.24% will surprise many people. “Horses for courses” is a phrase that springs to mind.

While creditors will always and only act in their own interests, they are more likely to trust a business with a strong profit margin to trade its way out of trouble.

I am wary of investing in the shares of companies where the nature of the business creates explicit completion for the so-called added value. This seems to me a regular problem with specialist service companies that offer consulting or outsourcing. Typically, employees are bonus-driven and customers are attracted by the promise of cost-savings through economies of scale or other efficiency gains. In good economic times, the employees can sell their services from a position of relative strength – in bad economic times, the customers have the upper hand and will demand price cuts in return for renewing contracts. So the pendulum swings from one to the other. Pendulums do not swing three ways and I have spent ten years looking for and failing to find the moment when things move in favour of shareholders.

This is why “high-end” service companies, whose assets are human, were once invariably partnerships: business consultants, accountants, investment banks and lawyers should simply not be listed on stock markets, in my view. The only arguable exception to this rule might be where employees are primarily remunerated in correctly valued (i.e. not discounted) shares, thereby more or less aligning their interests with those of outside shareholders. Given that it is no one’s interest that employees sell shares as soon as they receive them, here is an incentive to pay out dividends to all shareholders.

In summary, shareholders must be aware of competing interests for companies’ assets and be clear about how the shares are going to get paid out. There are really only four ways:

1) by the share price appreciating because the value of the company increases (this is the subject that obsesses most equity analysis);

2) by the equity’s share of the company increasing relative to the share of other liability holders (the Enterprise Inns example);

3) through direct pay outs in the form of dividends;

4) through the sale of the whole business at a premium. To detect the latter you need either an insider tip, on which you cannot legally act, or you need to understand why the dynamics of the industry imply that this business would be worth more to a competitor or related company than to an independent shareholder. Spotting takeover targets legitimately is by no means impossible and can be fun but there are no investment rules that I can think of to help one do it.

Rule 7: Big picture