The Valor Blog.
Investment News and Views, Direct from Our Team.

Capital Dependent and Capital Independent

There are two types of businesses in this world.

There are companies that are capital dependent and companies that are capital independent.

You generally only want to own the latter.

Its a bit like the story of two brothers. One who worked hard and supported himself through his wage and the other who had great dreams and many crazy business ideas, but floundered and went back to his parents for cash every few years because his income and cash had depleted. If you had the choice of investing in the hard working brother or the flounderer, it is an obvious choice. In the investing world, you have the same choice, buy unfortunately many people want to back the dreamer rather than the steady hard worker.

Most companies require capital over time. Some companies like airlines and start up mining companies consume capital like a herion junky. Even companies that are considered great companies can sometimes be capital dependent in difficult times.

During the GFC, numerous capital dependent companies were required to raise capital when their share prices were very low. They permanently destroyed capital.

Then there are wonderful companies like Berkshire Hathaway that always has a cash buffer and is capital independent. Warren Buffett was the saviour of numerous companies during the GFC throwing them a lifeline in their time of need when capital was sparse.

For most of the time the average investor doesn’t think about the capital dependency of a business. At Valor Private Wealth, it is paramount in our thinking.

We even go one step further…

If you own a capital independent company and you are a long term shareholder, then you actually want the share price of the business you own to go down. If this happens, the management who has spare cash up their sleeves can buy back shares and permanently increase your share of the company. This paradox is very far from the minds of those who value their shares by the popularity contest undertaken daily by the 1% of speculators who trade in their company every day.

Unfortunately in this short term world, some of our clients who dont understand our very long term views would feel uneasy because the share price of their businesses have gone down. We spend copious amounts of time attempting to educate our clients that owning wonderful businesses which have excess capital are even better when the share price dips and management buy back shares to increase your piece of pie in the company.

At present, two of our largest holdings, Coke (KO) (not the Australian subsidiary) and Berkshire Hathaway both have stated buyback plans. If the share price of these two wonderful businesses were to decline in the short term, we would be very happy with the outcome because it would allow Muhtar Kent and Warren Buffett to buy back shares and increase our effective holding in the business.

Converse to this are companies like the Australian banks. Although at this point in time, it looks as though the Australian banks are unlikely to need capital, I am not so sure this is a permanent situation. The Australian banks capital is leveraged off very high house prices. I would not blink if the situation arose where mining focused towns and cities had significant house price falls combined with continued weak conditions in Queensland and Victoria. In this situation, the banks may be forced to review their capital positions. This may not happen this year or even next year, but it is not a zero probability. If the Australian banks are required to raise significant capital in more difficult times, there could be permanent destruction of shareholders wealth.

A factor that affects the capital dependency of a company is the financial or operational leverage of a the business.

Financial leverage, is simply borrowing money.

Operational leverage is where a business can experience wild swings in its profit margins due to fixed costs and external factors which it has little control. This margin expansion and contraction can be very profitable for the enterprising investor who invests in a contrarian manner, however it can present problems when the good times are up for those not aware of its magnified downside.

Mining companies, manufacturing businesses and airlines are examples of businesses which can have operational leverage.

If you invest in operationally and financially leveraged companies, then you are generally investing in companies which are likely to be capital dependent at some stage in the future. It might be many years away, but if that company is required to raise equity during more difficult times, then you can permanently wipe away significant wealth.

A company such as Fortescue Metals runs this risk. It has both operational leverage and considerable financial leverage.

At Valor Private Wealth, we believe in finding businesses which we believe have a very low probability of ever requiring to raise capital. For those that don’t think about companies from this perspective, then you run the risk of potentially having greater losses during more difficult times.

Unfortunately over 70% of the Australian market is what we consider operationally leveraged. Add this to many being financially leveraged and it narrows your focus on wonderful businesses which can grow your wealth without the risk of capital dependency.