Solid Financial Position

Within our Ten Golden rules, there are those whose primary role is reducing the risk of a permanent loss of capital. Amongst them, the rule of having a solid financial position is likely the most important.

The principle is easy to understand. We look for companies that have little or no debt. There are many complexities when assessing the balance sheet strength of a company. For example, a company with volatile earnings, combined with low margins, can have a healthy ratio of debt to income at any given time. This is misleading though, as the situation can change in a heartbeat and quickly become unhealthy. The airline industry provides countless such examples. Added to this are difficulties that often come with gaining a good understanding of the true indebtedness of a company. As always, when taking a view on this some are more conservative than others. In our view, a company with a solid financial position is a company that has a strong balance sheet in all environments.

At Seilern, our starting point is drawing the line with a hard limit of Net Debt to EBITDA of two and a half times. This means the company’s debt should not exceed two and half years’ worth of earnings before interest, tax, depreciation or amortisation. While this is a clear hard limit we have, we cannot afford to stop there and think about it purely in mechanical terms. Other businesses with lower debt levels could still be excluded.

As always with us, it is not the law itself but the spirit of the law which is important. Many of the things we look for in companies, be it pricing power, structural industry growth, sustainable competitive advantages or geographic and customer diversification, are driven by the same underlying principle, which is to reduce the number of external factors which could negatively affect the businesses of the companies that we invest in. It is no different with debt, where we want our companies to be as isolated as possible from the vagaries of the debt market.

There are two primary ways in which a company can be affected by a contraction in the debt market. When interest rates rise, the performance of an indebted company, its economic value and its share price will be challenged by higher interest costs. This means that the earnings power of such a company will be affected by factors external to its business, that are hard for us to forecast. We would not want to invest in a high-quality business whose proceeds end up with the bond holders rather than the equity holders. Put differently, we want to invest in businesses, not their capital structures.

Secondly, and probably more importantly, we do not want any company we are invested in to get into serious financial trouble because of debt. If a business finds itself in a situation where it cannot roll over its debt, the consequences for its shareholders will be dire. This can happen to companies with the most solid of business models in situations where credit markets seize up completely and fundamentals do not play a role. These situations may be rare but should be avoided by investors whose holding period is indefinite, such as ours. Since capital is rarely a barrier to growth for the high-quality businesses on our investment Universe, an aggressive capital structure would be an unnecessary risk.

While a solid balance sheet is key, so too is understanding the accounts of a company and the ability confidently to ascertain its financial position. This will be the subject of our next Newsletter.

T. Seilern

01 February 2019

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