December 23, 2022
When Money Isn't Free
December 23, 2022
As higher interest rates make it harder to engineer growth through debt, we think the relative value of businesses that can grow organically should only go up. Learn how our companies are better placed to use their balance sheet resilience to enhance their competitive positions, increase the sustainability of return on operating capital employed (ROOCE) and drive steady, predictable growth.
Scientists believe that it takes most of us anywhere between two months and a full year to form a new habit. It would therefore seem reasonably safe to assume that two decades of falling global interest rates have left a lot of corporate managers and equity investors accustomed to debt available on demand, and at a fairly insignificant cost.
In fact, over the last 10 years, global corporate debt has grown from $53 trillion to nearly $88 trillion U.S. dollars (USD) at the end of 2021, reaching 98.5% of global gross domestic product1. Undoubtably, some of these funds have helped corporates to finance productive expansionary capital expenditures or invest in long-duration infrastructure projects; but freely available cheap debt can also be corruptive. It may tempt management to "juice up" returns through balance sheet leverage, to engage in acquisitive transactions that can help them to get paid on earnings per share growth (an incentive metric we truly hate), or in some cases invest on the assumption that capital is "free" as long as they are seen as a growth story.
Our investment process favours companies that generate a high, unlevered and sustainable return on operating capital employed (ROOCE). We are naturally suspicious of companies that rely excessively on financial leverage. For long-term equity investors like us, debt represents an asymmetric risk. When credit supply is abundant, management isn’t worried about bond repayment deadlines – for them it is simply a refinancing exercise. But when exogeneous shocks limit that credit availability, cash is once more king, and in a worst-case scenario, years of earnings growth compounding can be unwound by a debt call that reduces the value of equity to zero. To us this seems too high a risk to take for the few percentage points of extra return that leverage might bring. As the great Warren Buffett so elegantly put it, "A Russian-roulette equation – usually win, occasionally die – may make financial sense for someone who gets a piece of a company’s upside but does not share in its downside." We spend a lot of time thinking about minimising downside participation.
In fact, as the corporate world adjusts to higher global interest rates, we think this balance sheet strength will become a differentiating factor for the earnings and franchise resilience of our companies. The first-order impact is simple: lower debt levels today imply a lower drag on earnings when that debt is refinanced at higher rates. However, we also believe that our companies are better placed to use their balance sheet resilience to improve their long-term prospects. As our colleague Marcus Watson argued in an earlier Global Equity Observer, Scale and Diversification, ultimately, being able to invest in difficult times should enhance competitive positions, increasing the sustainability of ROOCE and driving the steady, predictable growth we look for.
Some of our companies are in the enviable position where their clients, through the normal course of business, regularly “lend” them large amounts of funds while demanding no return on it. This "float" usually comes from transaction balances that might have very short contractual duration, but in aggregate tend to be very sticky. These businesses are likely to see a tailwind to earnings as customer funds are invested at higher "risk-free" rates.
For example, the large U.S. software payroll provider we own benefits from just a few days’ gap between clients sending funds in and employees receiving their salaries. In aggregate, the company had average client fund balances of $32.5 billion in the last fiscal year, and its 1.4% yield on those funds is likely to increase with U.S. short-term rates trending higher.2
Similarly, a European exchange that we hold in some of our global portfolios, and that owns one of the world's major settlement and custody venues for international fixed income instruments, requires its clients to post cash balances to pre-fund settlements for bond transactions. Cash balances stand at approximately €18 billion (with approximately 50% in USD) and net interest income from these deposits increased more than fivefold year-over-year in the third quarter.3 This represents approximately 7% of group net revenue, with what is likely to be close to a 100% drop through to the bottom line.
In other instances, there is no commercial need for customers to entrust a business with funds, but they simply choose to do so for convenience purposes. For example, we own the largest e-wallet provider in the Western world, which usually holds more than $30 billion in customer accounts on its platform,4 there primarily to help fund future purchases. Although these funds can be withdrawn at any moment, so long as this e-wallet solution remains a convenient way for consumers to pay for their purchases online, it is reasonable to expect that these balances will stick around, allowing the business to receive interest income by reinvesting those funds into relatively safe fixed income instruments (such as U.S. government bonds).
As higher interest rates work their way through the economy, some behaviour that was facilitated by cheap debt is likely to disappear. Froth in the global housing market is likely to go away as consumers grapple with higher mortgage costs. We are also likely to see fewer advertisements for a shiny new grocery delivery business, for example, as investors reassess the opportunity cost of capital that is required to disrupt a new market. However, as it becomes harder to engineer growth through debt, we think the relative value of businesses that can consistently grow organically should only go up. As we’ve argued before, resilient earnings matter less in good times; it is when the going gets tough that the combination of recurring revenue (looking after the top line) and pricing power (looking after margins) really pays off.