Emerging Markets

Why we prefer companies with little to no debt

We appreciate sleeping comfortably knowing that, even in the worst of times, debt won’t be the variable that will cause an undue issue.
February 2019

Risk Disclaimer 

The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested. Investing in emerging markets is generally considered to involve more risk than developed markets.

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any stocks or products that may be mentioned.

We appreciate sleeping comfortably knowing that, even in the worst of times, debt won’t be the variable that will cause an undue issue.

The universe we live in includes bubbles and busts. Mr Market is rarely rational, meaning that no mathematical model can really explain what is going on, nor predict it consistently. As humans, we are uneasy when we cannot explain phenomena through theories. We quickly revert to past patterns, rarely questioning the limitations, and thus end up as part of the herd. Our industry is no exception.1

According to a CFA Institute research 59% of the polled investment professionals have less than three years to turn around underperformance or expect to get fired. https://blogs.cfainstitute.org/investor/2016/06/17/the-investment-risk-youve-never-calculated/

We think it’s important to recognise the pitfalls and shortcomings of previous theories and beliefs instead of blindly following them – and this has led us to prefer equity funding to debt funding. We appreciate sleeping comfortably knowing that, even in the worst of times, debt won’t be the variable that will cause an undue issue. We like to back managers who back their own convictions rather than follow the herd when it comes to managing balance sheet risks.

There are many ways that investments can go wrong, and we frequently see this with leverage in our part of the world, especially due to mismatches of dollar funding backed by volatile emerging currencies. We don’t want to lose sleep over leverage or currency bets going wrong.

Risk Disclaimer 

The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested. Investing in emerging markets is generally considered to involve more risk than developed markets.

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any stocks or products that may be mentioned.

You only find out who is swimming naked when the tide goes out.

Warren Buffett

In emerging markets, tides come and go regularly – and skinny-dipping is not our thing. For these reasons, we require a margin of safety and a solid balance sheet when we look for investment ideas.

Emerging markets have benefited substantially from a 30-year decline in interest rates, so in theory it makes sense for companies to increase their leverage when the cost is so low, to be able to make their next big (debt-loaded) acquisition, or perhaps to invest in a new factory. Major central banks and various other large institutions’ policies have been targeting this. The potential issue arises because most participants gear up together – not because it makes sense, but because they fear losing out.

Generally, peak market valuations are the time for the highest buyback programmes – but it should be the other way around. Across the emerging markets, higher debt levels can be seen from a top-down perspective.
 

Memories matter…

Investor memories tend to be short, especially those of us who haven’t been in this industry long enough to have felt severe pain. We believe the ability to recall the hard times is important, and we recognise this trait in some of the companies we hold in our funds. In Asia, we regularly meet companies that still talk about the Asian Financial Crisis 20 years later, either how they survived or changed their attitude, or what they did to prepare for it. It’s music to our ears because they have clearly learnt their lessons. The companies in our portfolios typically want to keep their cash for a rainy day and look for the moment when they can buy out their key competitors at reduced valuations, or invest when no-one else is to strengthen their market position.

Like a house with no mortgage being worth more than a house burdened with one, we are happy to pay up for quality companies with sensible balance sheets and strong franchises, backed by capable and honest stewards.
 

…And so does motivation

As investors, we spend a lot of time trying to understand the debt conundrum and whether this relates to an attitude of a long-term owner instead of an empire builder. The motivation of the family behind the business or the manager running the company tells us a lot about risk appetite and whether they are someone who is willing to put stakeholders at risk. Equally, the debt structure may simply indicate a weak business model that requires borrowing in order to compete and remain relevant.

We actively search for sound businesses with co-owners who understand the importance of the journey rather than the destination in order to build strong fundamentals upon which the businesses can prosper. Most importantly, we look for business owners who are responsible not only for their shareholders but also their employees, as a way to enhance and improve the communities they touch by being long-term partners, and not just shooting stars that hire and fire. We believe having capital for rainy days is one of the best indicators of such vision in practice.

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Emerging Markets