Since the world financial crisis began in mid-2008, high-quality investments have greatly outperformed lower-quality ones. It hasn’t been a straight line outperformance by any means, given the bouts of government risk subsidization that we have seen in 2009 and 2010, but it has been significant and persistent, especially in times of stress like October 2008 to March 2009, and the last half of calendar years 2010 and 2011. Today we are going to examine why that has occurred. We will begin by discussing the sources of volatility in equity markets in general.
There are two fundamental reasons that equities as an asset class have much higher levels of volatility than most other assets. One is the operating leverage built into many companies; the other is the embedded financial leverage in the companies’ own balance sheets. Let’s consider the implications of these types of leverage.
Operating leverage comes from a business model that has a lot of what accountants call “period costs,” or “fixed costs.” These are costs that a company will incur regardless of its level of economic activity. For example, a company with a large mine or factory will incur costs relative to the depreciation of the machinery in such an installation, its labour force, utilities, etc. If prices and/or volumes for the product they produce fall in the period, these costs will not fall and the profit impact will be immediate and strongly negative. Generally, the higher the level of fixed assets, and therefore depreciation, in a company, the higher the operating leverage. In recessions, or periods of slow growth, when prices are under pressure and volumes tend to fall, the impact on profits of companies with high operating leverage is dramatic and painful.
Financial leverage shares some of the characteristics of operating leverage in the cost structure of a company, but adds some additional risks. Clearly, the interest paid on its debts is a period cost for the company that will depress profits in the event of a fall in the prices and/or volumes of a company’s products. But there is the additional complication that debt has a prior claim on the assets of a business, meaning that your interests as a shareholder are subordinated to those of the bondholders. And debt has to be continually rolled over and refinanced, which is no problem for a business with a strong balance sheet but can be acutely embarrassing or even fatal for a business that has to refinance a heavy debt burden in a time of financial stress. If the company has to refinance at a punitive interest rate, the level of profits available for common shareholders is severely reduced. If the company chooses to refinance with equity, the common shareholders may face massive dilution. If the company cannot refinance at all and goes bankrupt, the common shares are most likely worthless. In any case, the plight of a common shareholder in a company with high financial leverage in difficult times is not a happy one.
Benchmark equity portfolios often contain a large number of companies and industries with high operating and financial leverage. For example, the Canadian benchmark S&P/TSX Composite Index has over 77% of its market value in companies in the Financial Services, Materials and Energy sectors. Financial Services companies (especially banks) have a great deal of financial leverage, while by definition commodity producers like energy and materials companies will have high levels of operating leverage. Canada is therefore vulnerable to a slowdown in demand for commodities, which would hurt the materials and energy side of their businesses through operating leverage. It is also vulnerable to a domestic recession, which would hurt the financially-leveraged bank stocks. The fact that neither of these events has happened in the past decade is more due to good luck than good management.
A useful definition of quality equity investments would be companies that are low in both financial and operating leverage. A simple business with a strong balance sheet, that also possesses the characteristics of high margins and the ability to finance its growth and expansion through internally generated free cash flow, would generally fit the bill. Such companies would have more resilient profits than other companies, would face no financing challenges and would be able to take advantage of cheap asset prices to expand and grow their businesses.
Burgundy’s style is to seek out high-quality companies like those described above, buy them at attractive prices and then hold them for the long term. And while nothing is ever guaranteed in the capital markets, and the quality companies will never fully participate in wild, risk-taking bull markets, we at Burgundy have always felt that the downside protection they offer more than balances the more restrained upside. The markets of the past three years, like other difficult markets before them, have consistently proved this belief to be well founded.