Rusting Away In The Yard
“The more sophisticated electric utility maintains – perhaps increases – the quarterly dividend and then asks shareholders (either old or new) to mail back the money. In other words, the company issues new stock. This procedure diverts massive amounts of capital to the tax collector and substantial sums to the underwriters. Everyone, however, seems to remain in good spirits (particularly the underwriters)”
How Inflation Swindles the Equity Investor, Warren Buffett, FORTUNE, May 1977
I was interested to read the above passage the other day (the whole article is well worth a read). Despite being written by Buffett in an era of much higher inflation and interest rates, it could have been written today rather than 33 years ago. This month National Grid (a ‘sophisticated electric utility’ you might say) announced a rights issue to raise £3.2bn while simultaneously announcing a full year dividend payment up 8% at a cost of £1bn to the business. Following a further 8% increase next year, it's forecast to pay another £1.3bn in dividends. For presentational reasons the management argued that the new money raised will be used for growth. Viewed through another lens, however, 70% of this new money will simply be mailed back to shareholders via the next two years of dividend payments. At least it keeps the underwriters happy.
National Grid is not a bad company. Quite the opposite - operationally it’s a well run, growing business and provides an essential product to both the UK and the US public. Being a utility its return on capital, though low, should also have some downside protection. However, Grid's latest announcement neatly illustrates a point - asset-heavy businesses can only achieve growth by throwing large amounts of capital at the problem, not something conducive to the creation of long-term shareholder returns. While asset-heavy business models may creak along well enough in the current low interest rate world, I’m not sure how well they will cope if faced with significantly higher inflation and interest rates. History suggests they will fare poorly.
Any company's ability to generate long-term shareholder value (i.e its return on equity) can be broken down into three elements - its profitability, capital intensity and debt levels*. In other words, company management can do three things to improve shareholder returns - increase profit margins, improve asset efficiency or raise debt levels.
Unfortunately this means that companies that struggle with the first two factors will increasingly turn to the third factor (higher debt levels) to eke out acceptable profits and dividend payments for shareholders in a low growth environment. This trend can be clearly seen in the UK market - total debt held by FTSE Allshare companies has more than doubled from the end of 2007 to today, rising from just over £1 trillion to nearly £2.5 trillion today.
However, higher interest rates would render this approach unworkable. Some of these businesses will be forced to raise fresh equity instead and ultimately per-share dividends will suffer.
We prefer exposing ourselves to the first two levers of shareholder value creation – high profitability and high capital efficiency. Because they have fundamentally attractive economics, these businesses generate excess cash-flow and have much lower debt levels than the market average - they don't need debt to generate an attractive return. This strategy – of focusing on unleveraged, high return businesses - is fundamental to our approach. Charlie Munger sums up the idea nicely in the following quote:
"There are two kinds of businesses: The first earns twelve percent, and you can take the profits out at the end of the year. The second earns twelve percent, but all the excess cash must be reinvested - there's never any cash. It reminds me of the guy who sells construction equipment - he looks at his used machines, taken in as customers bought new ones, and says, 'There's all of my profit, rusting in my yard.' We hate that kind of business."
While nothing is certain, we believe this to be a robust approach to achieving both inflation protection and a sustainable dividend stream for the portfolio.
An afterthought on China
Taking this thought a little further, China’s recent economic growth seems to embody at a country level what we are trying to avoid at the company level. As the years have gone on China’s growth story has needed more and more capital to generate each marginal unit of GDP growth, with a heavy skew toward infrastructure and property development. The make-up of China’s growth will need to change from capital formation to consumption over coming years. If it doesn’t, China’s empty commercial offices and residential developments will look increasingly like Munger’s profit - 'rusting away in the yard'. We are, as a result, very wary of any stock that looks particularly reliant on the continued buoyancy of this part of China's economy.
Please note, this investment view contains the personal opinions of Hugh Yarrow as at 1st June 2010 and does not constitute investment advice.
*Geek's note - this is known as a DuPont Analysis