High levels of leverage creeping into certain segments of the UK market such as telecoms, utilities or the consumer staples sector should be a warning sign for investors, according to M&G Investments’ Sam Ford.
When considering the UK market recently, Ford – who is lead manager of the £586m M&G UK Select fund – said he has seen increasing amounts of debt being taken by firms recently to finance their assets.
“The growing levels of debt creeping into public markets is something that I’ve been thinking a lot about, because often it can happen quickly and balance sheets can change quite rapidly,” he explained.
“We are very mindful, we don’t want to achieve premium returns by taking lots of leverage.”
This balance sheet risk that characterises those funds that invest in highly-leveraged companies to achieve premium returns, he said, tends to work well in healthy markets but will pose challenges when volatility rises.
“The second [that] volatility emerges you can often find yourself with quite a problem so, the companies we like have really strong balance sheets and, in some cases, net cash,” Ford explained.
Examples of these leveraged businesses can be found in the utilities and telecoms sectors, where he highlighted companies like British multinational conglomerate Vodafone Group.
The telecoms company has grown exponentially over recent years thanks to merger & acquisitions (M&A) activity, it has a total debt to equity ratio of 57.67 per cent and it was 1.9x levered for the fiscal year ending in March 2018.
Performance of Vodafone YTD
Source: FE Analytics
“Companies like Vodafone are looking to acquire their European rivals as they look to try drive scale into their business model and cut costs,” said Ford.
“Often, leverage can make the companies look defectively cheap because, with the level of debt it can look like the earnings profile can be quite high.
“But it doesn’t tell you the story of the risk that sits behind that from a balance sheet risk perspective. If the revenues turn you can often find yourself in a difficult position.”
He explained: “This adds to the level of complexity and is something we feel we have to look at more. Often, if we can find the option to buy growing earnings and dividend profiles without that financial leverage it’s always a safer bet where you can minimise the downside.”
The issue of corporate indebtedness has started to worry policymakers, with the Bank of England recently issuing a warning over the rapid growth of leveraged lending to UK businesses, mirroring global trends.
The Bank’s Fiscal Policy Committee said the gross issuance of leveraged loans by UK non-financial companies had reached a record level of £38bn in 2017, with £30bn having already been issued in 2018.
However, despite rapid growth of leveraged lending, overall UK corporate lending growth is more moderate and has slowed in the year more recently, with growth in lending to small- and medium-sized companies slower than for larger companies, it noted.
Yet, high leverage alone will not preclude an investment as, according to the M&G UK Select fund manager, some of the companies the team holds have also taken on debt to finance operations.
“It has happened to a few of our companies and some of them we went through a pretty tough time,” he said. “Software and information technology business Micro Focus took on debt to buy a US business and it has had a really tough time, but we maintained our position, in fact, we added to our position during the falls of this year.
Performance of Micro Focus over 1yr
Source: FE Analytics
“But this is a company that in theory should have a very predictable level of revenues they can service the balance sheet and actually we are pleased to see that the company sold part of itself – which will close very soon – to fund the leverage that existed in the business.”
To find the winning companies for the £586m fund he oversees, Ford said that the team tries to understand the competitive advantages that a business has.
“Competitive advantage links to the companies’ ability to earn fantastic levels of return on the investment they make,” said Ford. “But, competitive advantage is based on several characteristic elements of the business, like culture for example.
“We spend huge amount of our time going and speaking to our companies understanding what lies beneath. We ask ourselves: do we think management teams aim to grow the business at any cost or genuinely trying to motivate staff and generate returns for shareholders?”
Ford also noted that issuing a dividend is a great discipline for company management to have: automatically apportioning a part of the company’s cashflow to its shareholders giving them a chance to re-invest that dividend.
“We think over time if you can correctly identify those companies you can form pretty meaningful outperformance relative to wider UK market,” he said.
Given the uncertainty dominating UK markets, Ford said having diversity of ideas across a portfolio is also important, hence the need of diversifying across sectors.
Some of examples of winning growth companies in different sectors the team favours include Scottish soft drink manufacturer AG Barr, Dechra Pharmaceuticals and real estate information company ZPG, he said.
Performance of fund vs sector and index over 3yrs
Source: FE Analytics
Over three years, the M&G UK Select fund has delivered a 17.49 per cent total return compared with a gain of 20.90 per cent for the average fund in the IA UK All Companies sector and a 23.94 per cent gain for the FTSE All Share index. It has an ongoing charges figure (OCF) of 0.91 per cen