Albert Einstein allegedly described compound interest as the eighth wonder of the world. “He who understands it earns it; he who doesn’t pays it,” he reportedly said. Who needs unified field theory?
Today we are all living in the shadow of compounding. We now appreciate that an epidemic can build quickly if each person with the virus infects more than one other. Such is its power.
Most (prudent) investments do not have quite the same rate of compounding as we have seen with Covid-19. They need the vital element of time. And that means choosing companies that will last.
We face a deep recession and high unemployment. Furlough payments and central bank support through cheap loans will not be here forever. As lockdown lifts, we will see which companies have the strength to clamber back up to fight another day and which do not. If you have not reviewed your investments lately then it is worth doing so soon.
The world’s longest-lasting company, Kongo Gumi, founded in Japan in 578, may give a few clues as to how to identify a business with durability. It built Buddhist temples. Usefully, the cedar used to construct these needs continually replacing. So it was a specialist business with recurring income. It was finally taken over by a large construction company in 2006, when it fell into receivership after the management took on heavy debts — not helped by making dodgy investments in the 1980s real estate bubble.
The lesson? Choose companies that stick to what they are good at and make sure you understand how much debt they are carrying. This is not as easy as you might think. Accounting standards were developed principally to allow banks and other creditors to assess the stability of a company. Accounts help equity investors, too, but they can take some interpretation — especially if you are investing globally, as the rules and practices differ in every region — and debt can come in a number of forms. Here are some things to consider in the current climate.
Is a deluge of debt heading your way?
Remember that accounts offer a snapshot at only one point in time and circumstances have changed dramatically. You need to make adjustments to last year’s statements to assess any weakness. Stress-test the foundations by looking at the operating cash flow ratio (profits with non-cash expenses added back divided by short-term liabilities shown in the accounts). This tells you how many times a company can pay off current debts with cash generated within the same period. If it is less than one then the company needs more capital.
Even if the number is more than one you may not be safe. Check the current level of cash obligations — interest payments, lease obligations (especially for retailers) and staff costs when furlough help ends. Compare these with the cash profits the company is likely to have.
Consider, for example, whether firms that have been closed will be able to reopen as normal or whether social distancing will make them unprofitable. Is a company’s debt likely to be building sharply? This obviously requires some assumptions, but it is mainly common sense.
Thinking about the numbers in this way may trigger alarm bells that save you from losing money.
Is there a hidden cost to keeping the business competitive?
For a company to survive in good shape it needs to invest in its own business — in product development, brand and equipment. When we select stocks we try to look at the capital expenditure the company has made over the past decade. We compare this with the company’s revenues and against other companies in the same industry worldwide. We also compare capital investment with the depreciation figure shown in the cash flow statement.
Depreciation gives you a sense of how much a company should be spending to keep its plant and equipment from falling into disrepair. One could boast good cash flows in the short term but produce these by running down the company.
While a fair and basic guide for an industrial business, depreciation hardly captures the level of capital investment a software company, for instance, would have to make to remain competitive. We therefore expect to see higher levels of investment in these businesses — sometimes appearing as capital expenditure, sometimes as research and development and sometimes as higher spending on staff as a company grows. If a company is not making these investments then it is building a business maintenance debt.
Is a management debt accruing?
Small business owners who are paid largely by dividends know how easy it is to make their profits look good — don’t include within the calculations a fair market wage for yourself. Bigger companies can do a form of this, too. Many technology companies pay their management and some staff principally in shares. These shares could be bought in the market and the cash cost captured in the accounts. We look for the ‘stock-based compensation’ figure and charge this against cash income, because when markets fall this form of remuneration may prove a poor way to retain the best staff — and a company may need to go back to paying in cash.
This sort of analysis can kick out some positive surprises as well as shocks. In Japan, land and property often appear on the balance sheet at cost. I have found some that have been 100 years out of date. That can put an entirely different gloss on the numbers!
If you want to take investing seriously it is worth consulting the literature on how to interpret company accounts and read between the lines within them. It’s not that daunting and could improve your investment choices considerably.
Simon Edelsten is co-manager of the Mid Wynd International Investment Trust and Artemis Global Select Fund