Saturday, September 20, 2014

Understanding a little bit more on debt and gearing

There has been a decent number of going concern recently from fellow bloggers that taking on debt is seen as a no go and some even try to completely avoid them as they are seen as a bad apple. Similarly, the approach these very same people take when it comes to investing is to filter off companies whose debt or gearing ratio reaches a certain threshold, say above 50% or 70%, depending on one threshold.

While the above imposes certain sense of prudent investing, my purpose of writing today is to open up an explorable idea that undertaking certain kind of debts need not inherently be a bad idea and if you are one of those who filter off these companies completely just because they are laden with debt, you may be missing out on some good companies out there.



Just like how using credit card prudently can be beneficial to most of us, a company that uses debt need not be inherently bad. As a matter of fact, debt is almost always a much cheaper form of financing than equity. Take MGCCT for instance, their current gearing stands at 38.6% and costs of debt is at 2% due to their ability to obtain financing during the period of low interest rate environment for their strong sponsor. If you are one of those investors who have strict criteria in your investment to filter off companies with gearing more than 35%, then you would inherently miss out on this counter. In fact, MGCCT is one of the few reits with the one of the lowest costs of debt out there and yielding pretty decent returns for the shareholders. Their ability to cover these interest costs are also pretty decent with coverage ratio at 4.8x.

Secondly, debt can also be a form of tool to boost the company's Return on Equity (RoE), especially when their other levers such as operating and asset efficiency are not performing well. Ironically, I have encountered a blogger who avoided investing in Reits because of the high leverage but choose to invest in Starhub instead. I'm unsure if he realises that Starhub has a pretty high debt/equity ratio, coming down from as high as 16x to the current of 8x.

Third, gearing of a company is often a function of both the numerator and denominator - liabilities over equities or assets. But many investors look at gearing as a form of control only on the liabilities side and often the other part was neglected. Take SPH for instance, when they spin off their Paragon and Clementi mall into the SPH Reit, their gearing falls from 40.6% to somewhere around 8%. The immediate reaction from the crowd was the amount of debt goes down but that is not the case. Apparently, gearing goes down because equities have now risen resulting from the sale of those assets. Similarly, most assets are revalued at least once a year so this will also affect the nature of the gearing.

Finally, I am writing this post not to debate whether taking on debt is a good or bad thing but rather hoping to open up how people can view debt in a different light. Just as Howard Marks view risk differently than the traditional with higher risks not necessarily equal to higher returns, the same view can be said with taking debt and they are often not necessarily a bad thing to have in your balance sheet.



                                                                                                  

7 comments:

  1. Replies
    1. Thanks Uncle CW.

      Still, there are a couple of management who are very prudent in using leverage as a means to boost their RoE.

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  2. Hi B!

    I personally find this blog post compelling and debatable.
    It's a fact that no good corporations can live without debts.

    Although it is true that with a low cost of debt (at 2% as per example) the firm, could simply leverage it with higher returns and not prioritising to clear the debt.
    However "what if the company production/revenue stops suddenly and has to liquidate due to reasons like fire, flood, lawsuit, government intervention, etc."
    In these scenarios, gearing comes into play. With a high gearing, I can be sure that almost all of the proceeds from the assets go to the creditors(banks, partnerships, bonds) since they are first in the line. Even worse, vast shareholders will only get a split of what's left by preferred shareholders.

    On the other hand since a high gearing company is more vulnerable to downturns in the business cycle because they have to continue to service its debt regardless of how bad sales are, Starhub being an essential info-communications service provider in this society, its services would most likely be demanded even in downturns. However REITs' vulnerability depends largely on their ability to collect rent consistently. In times of depression, even one company's liquidation and inability to pay its rent, the losses could be multiplied due to leverage and lack of demand in those times.

    Lastly these are just my opinions and I might be wrong or wrongly educated about REITs. If so, anyone not just B, please enlighten me! :)

    Regards,
    The IA

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    Replies
    1. Hi TIA

      Thanks for your input.

      I hear what you're saying. With debts, there will always be inevitable questions about whether the company is going to be able to refinance their loans during bad times and are more vulnerable as well.

      On the point of starhub, the fact that the other two telcos have a much lesser gearing than starhub questions where the RoE from starhub comes from. Good or no good? They appears to be doing very well right now so loads of debt no problem with them. With reits, there are some with stronger sponsors and stronger credit ratings who are able to refinance better than the others so I guess it applies kinda same in different environment.

      Good stuff up there for debates. Keep it going. Appreciate it.

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  3. Gearing depends on industry. If you look at banks their are extremely geared, but that doesnt mean all of them are very risky. Telcos should be measured differently too, the physical assets that they own are worth very little, however they have many intangible assets such as their network of customers that provides a steady stream of revenues. Normally analyst do not use debt/equity but ebita/debtinterest instead

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    Replies
    1. Hi Felix

      Fair points you've brought up there. That's the point I would like to find out.

      Different industries have different measures of risk indicators that we've got to look out for. There are no fixed and hard rules number what percentage of gearing is good. Because of this, retail investors may be missing certain types of stocks if the criteria is too stringent on gearing.

      Good points you brought up.

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  4. For comparing the riskness of telcos against its peers, normally better to use interest coverage ratio instead

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