Chris St John, Portfolio Manager, AXA Investment Managers
Previously, we have addressed the characteristics that we look for when investing in growth stocks. In our view, well-capitalised companies that can grow profits, cash flows and dividends offer the best potential for equity investors.
For equity investors, a vital element in realising these gains is the ability of the company to translate its profit growth into returns for the equity holder.
Most listed companies have a mixture of debt and equity making up their capital structure, both of which can be used to help expand or generate growth. However, for equity investors to maximise the chance of capturing the benefits of this growth, the financing structure of any business needs to be such that the actions of the board, and the subsequent financial gains, benefit the equity holder not just the debt holder.
When a company has too much leverage, its debt-servicing obligations can become onerous. The seniority of debt within the capital structure of corporates means that interest payments to debtholders take priority over dividends paid to equity holders.
All other things being equal, for an increase in the debt held by a business, a commensurate increase in the debt servicing costs will occur, leaving less free cash flow to reward equity holders.
This can restrict the distribution of profits and inhibit investment in further growth. As equity holders, this situation is clearly sub-optimal. With the balance of power in the hands of the debt holder there is reduced scope for returns to filter through to the equity holder.
Excessive debt also has the effect of increasing financial risk. In companies with a higher debt-to-equity ratio, for a small change in a company's enterprise value (the value of a company's debt plus the value of its equity), the effect on the equity value is magnified, causing the equity to become relatively more volatile and therefore risky.
An extreme - and simplified - example of this problem can been seen in the residential property market. On the assumption that house prices ‘generally go up', people can be tempted to overextend themselves when taking out home loans.
Consider buying a house worth £100, with a deposit of £5 (equity) and mortgage debt of £95.
If the value of the house falls by £5 or more, you will lose 100% of your deposit (equity).
Alternatively, if you buy the same house with £100 cash (equity), a £5 fall in the value of the house will result in just a 5% loss in equity value.
The effect of debt on the volatility of the equity value works in exactly the same way when considering corporates.
The potential pitfalls of too much debt all support our conviction for investing in growth companies with strong balance sheets. With appropriate levels of equity in a business, companies can confidently pursue and capitalise on growth opportunities, without all of the benefits being diverted to service (debt) interest and capital repayments.
A management team that is focused on nurturing a well-capitalised company by maintaining a healthy debt-to-equity profile will retain the capacity to act in the best interests of the equity holder. Ultimately, this will enable the benefits of growth - in the form of dividend distribution and share price appreciation - to accrue to the
equity investor.
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Author Name: Chris St John,
Position: Portfolio Manager, AXA Framlington UK Mid Cap Fund and AXA World Fund Framlington UK. Chris has been a portfolio manager at Framlington Equities since 2005 responsible for managing UK multi-cap and mid/small cap strategies. Prior to AXA IM, he was Lead Portfolio Manager on institutional and retail FTSE Small Cap portfolios at ISIS (now F&C Asset Management).
Chris started his career at PricewaterhouseCoopers in 1995, latterly specialising in valuing unlisted businesses, before moving to Friends, Ivory & Sime as trainee fund manager. Chris holds a degree in Philosophy/Psychology from Durham University; he is also a Chartered Accountant .
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