11 small caps on steroids

The Leverage Small Value Equities approach also chimes with a strategy employed by our small-cap columnist Simon Thompson for smoking out small-cap opportunities, which he covers in his latest, highly-readable book, Successful Stock Picking Strategies.

To some extent this value investment strategy flies in the face of conventional wisdom. That’s because value investors are often very nervous about companies that carry a lot of debt. High borrowings add to the risk of buying shares in a company that is down on its luck reducing a value investor’s much-prized “margin of safety”. However, Mr Chingono and Rasmussen’s research suggest it can sometimes be worth forgoing safety in order to get exposure to what they term “small-cap value on steroids”, especially using a diversified portfolio.

The mechanics of debt paydown

While high debt is a risk, it can be a wonderful thing for equity holders if a company is able to pay it down while maintaining profits. By paying down debt a company effectively transfers value from debt holders to equity holders, while at the same time potentially increasing the perceived quality of its business to prompt a re-rating of the shares.

The concept of enterprise value (EV) is important in illustrating how this works. In its most basic form, EV represents market capitalisation plus net debt. Net debt is added to market capitalisation to reflect the value put on a business’s the key sources of financing: equity (market capitalisation) and debt. Other debt-like liabilities are sometimes added into an EV calculation, too, such as pension deficits and lease commitments – we’ll ignore these for now.

To see why the concept of EV is important when looking at the impact of debt paydown on equity returns, we can start with the example of a company that is producing cash profits (also known as earnings before interest, tax, depreciation and amortisation or Ebitda for short) of £10m a year. Let’s suppose the company is assigned an EV equivalent to five times its Ebitda (EV/Ebitda is a popular metric used in takeovers). That gives the company an EV of £50m. If this company has £25m net debt, it will therefore have to have a market cap of £25m to get it to its £50m EV.

Now what happens when this hypothetical company starts paying down debt? If we imagine the company finds a way to pay back £5m of debt (half Ebitda) a year while EV/Ebitda is maintained at 5 and Ebitda remains unchanged at £10m, which keeps EV at £50m. After one year net debt is down from £25m to £20m, so market cap will need to rise from £25m to £30m (a 20 per cent increase) to maintain EV. In other words, with no growth and no rerating shareholders can see a 20 per cent gain.

If the market likes the debt reduction strategy the valuation of the company may re-rate. Say EV/Ebitda increases to 5.5 times after a year. With Ebitda maintained at £10m, EV will rise to £55m. Our reduced net debt figure of £20m means market cap will now need to make up the remaining £35m of the higher EV. This would be equivalent to a £10m increase in market cap - a 40 per cent rise in the value of equity – from debt paydown despite the assumption of no profit growth.

The impact of debt paydown is magnified for shareholders the lower a company’s EV/Ebitda rating is and the higher the proportion of net debt to market cap in EV. Indeed, the three tables below illustrate how the big share price gains from debt payback are experienced at the start of the process and that the upside is theoretically magnified at lower ratings. Returns are exaggerated further when shares are re-rated as a result of reducing debt.

What’s also of note, is that for two companies with the same debt ratio based on net debt/EV that pay back the same monetary amount of debt each year, the one with the lower rating based on EV/Ebitda will get out of hock faster. In the accompanying tables, where all companies start with net debt equal to market cap, the company valued at an EV/Ebitda of 5 pays off all debt in 5 years compared with the 10 years take by the company with an EV/Ebitda of 10.

All this raises the quixotic issue of when the gains from debt paydown should trump the need to keep capital investment at a healthy level – no surprise under-investment is a charge often levelled at leveraged buy outs.

Source: IC

Hunting for small-cap value on steroids

The strategy set out by Mr Chingono and Mr Rasmussen to take advantage of companies paying down debt is to target small, cheap companies with high levels of debt that look well placed to reduce borrowings. Mr Rasmussen has a background in private equity, and his contention is that this approach replicates the key drivers of the historical high returns made by private equity.

Mr Chingono and Rasmussen looked at a number of factors as indicators of the ability of a company to paydown debt, the most powerful of which was simply whether or not it had managed to reduce borrowings in the previous year. As the authors put it, “cheap and leveraged companies that have been actively paying down debt are in a different position from companies that have recently raised debt because of an inability to generate sufficient internal funds.”

They also found companies that showed improving asset turnover (sales as a percentage of assets) tended to perform better. This makes sense because, all other things being equal, if a company needs less capital to generate each pound of sales, it has more capital available to devote to other things, such as paying down debt. The benefits of improving asset turnover should be amplified for higher-margin businesses and companies with a high level of assets to debt. Indeed, another quality measure used by Verdad funds is gross profit/assets, although I have not included it in the criteria for this screen.

All in all, the authors reckon, “the ideal leveraged stock has high gross profits/assets, and low-to-moderate long-term debt/assets, a low valuation in terms of EV/EBITDA, and a high level of long-term debt/EV.”

While Mr Chingono and Rasmussen were interested in creating investible portfolios using rankings based on their regression analysis, I’ve adapted their screen to fit more with this column’s key aim of highlighting interesting ideas for further research. It should be emphasised that the stocks highlighted are high-risk in nature and Verdad constructs diversified portfolios for its funds to mitigate the dispersion of individual stock returns. For example, the 38 stocks in the global fund’s 2016 portfolio produced returns ranging from an astronomical 394 per cent to a ghastly -75 per cent, with a median return of 24 per cent. The criteria, conducted on all stocks in the FTSE All Share, All Small and Aim indices, are:

Among the cheapest quarter of stocks based on EV/Ebitda

A market cap of less than £750m but more than £25m

Net debt to EV higher than the median average of all companies with net debt*

Improving asset turnover over the last 12 months

Falling net debt over the past 12 months*

*The “Leverage Small Value Equities” looks at long-term debt rather than net debt as this makes for cleaner historic comparisons whereas the Verdad funds focus on net debt.

A total of 11 stocks met all these tests and they are presented in the table below ordered by a combined ranking based on EV/EBITDA (the cheaper the better) and long-term debt/EV (the more indebted the better). I provided a write up of the most indebted company in the table to give a flavour of how spicy these situations can be.

11 small caps on steroids

Source: S&P CapitalIQ

HSS Hire

In the introduction to their paper, Mr Chingono and Rasmussen borrow a phrase from one of their former teachers, Professor Robert Vishny, to describe investing in highly-indebted, cheap smaller companies as “small-value on steroids”. The stock on the strongest “steroids” highlighted by my screen is HSS Hire (HSS). Its net debt is almost four fifths of its enterprise value – deep gulp!

High leverage is only a plus point for investors if it can be reduced, and when a balance sheet is poised as precariously as that of HSS, it’s not hard to imagine scenarios where the interests of shareholders could be subsumed by the higher-priority interests of lenders. That said, by simply paying down debt the rewards to HSS shareholders could be huge and management have made this their strategic priority.

As a guide to value, Ebitda is a rough and ready way to gauge a company’s cash-generation potential (Ebitda is an earnings number rather that a real cash number), and investors must be wary about the significance of the things excluded from the Ebitda calculation. In the case of HSS, which reported adjusted Ebitda of £49m last year but a £12m underlying loss before tax, there are two very noteworthy items investors need to bear in mind: the depreciation charge (the “d” in Ebitda) and the interest charge (the “i” in Ebitda).

Given the capital-intensive nature of equipment-hire businesses (owning lots of expensive equipment to rent out) the depreciation charge for a firm like HSS is large and also to a significant extent reflects the on-going cost of maintaining operations. Last year depreciation came in at £37m and amortisation at £6.6m. If anything, over recent years HSS’s depreciation charge looks like it has been on the light side given the small losses the company has reported on hire equipment sales and larger charges relating to hire-fleet write offs and “accelerated depreciation”.

Interest is also a big expense. On the plus side, if debt is brought down, interest costs will fall increasing the benefit to earnings and boosting the company’s ability to pay down debt – a virtuous circle. However, at the moment the company pays a lot to service its debts and the bill look set to rise following the refinancing of secure loan notes paying 6.75 per cent with £220m of debt paying between 7 to 8 per cent above Libor. The lender has also received 8.5m warrants (equivalent to 5 per cent of shares in issue) exercisable at 1p, meaning potential dilution in the future. Broker Numis forecasts interest payments will consume £14.3 this year jumping to £21m in 2019 as the impact of higher-cost debt kicks in. But while the rise in finance expenses is not nice, it’s arguably a bigger positive that the company’s immediate future is secure.

Clearly HSS faces an uphill battle, but under the leadership of Steve Ashworth who was appointed in mid-2017, there is a clear strategy in place and progress is being made. A significant cost saving programme has been put in place to scale back the supply network and save £11m a year, with exceptional costs of £41m booked in 2017 relating to this. The programme is expected to cause a £3m cash outflow this year but boost cash generation by about £8m a year thereafter.

Significantly, the company has also agreed the sale of one of its specialist hire business which, pending fourth quarter approval from the competition and markets authority (CMA), should bring in £47.5m cash. At least 80 per cent of the money (£38m) is earmarked to pay down debt with the rest expected to be invested in improving the troubled, core tool-hire business.

Meanwhile, operational progress is being made with tool-hire utilistation rising from 46.5 per cent to 52.3 per cent in the first half and strong trading persisting into the second half. There should be plenty further to go, considering Ashtead-owned rival A-Plant routinely achieves utilisation rates in the high 60’s and low 70’s. The services business, which requires far less capital than the hire business, is also growing strongly, although, it only accounts for about 7 per cent of profits. Trading progress, along with falling costs led to a 75 per cent jump in underlying first-half Ebitda to £30m, although the group still made a £700,000 underlying loss before tax – a marked improvement on the £14.2m loss reported 12 months prior.

The company has been squeezing working capital to generate more cash, although the timing of fee payments related to the costly refinancing led to a temporary increase in receivables (money or services yet to be received) at the half-year stage. HSS is also cutting back on capital expenditure to improve cash generation with £5m shaved off the bill last year. Underinvestment in such highly competitive market is a risk, though, and balancing the need to generate cash with the need to keep the hire fleet up to scratch is likely to be tight-act in coming years. Furthermore, onerous leases related to store closures have led to provisions on the balance sheet ballooning to £48m, which represent a future drain on cash flow. Accounting rules to bring lease liabilities onto the books from 2019, while cosmetic, will further illuminate the strain on the balance sheet.

HSS seems to have the right focus and trading looks supportive. What’s more, the state of the balance sheet means selling businesses to pay down debt looks a sensible course of action even if it is at the cost of future profits. However, debt sometimes goes past a point of no return and while recent share price performance suggests the market is gaining some confidence in the situation being salvageable, there is still plenty of room for doubt. High potential reward, but definitely high risk.