TROUBLED TIMES? ASSESSING FINANCIAL AND STABILITY RISK IN THE STOCK HOLDINGS

 FUNDAMENTAL RISK ANALYSIS OF PORTFOLIO

One of the reasons I am comfortable holding such a large percentage of my wealth in risk assets is that those companies are conservatively financed, and the underlying businesses are sound and will not fail if there is a large external shock. Here I look at the businesses, not the expected share price reactions, which could, and probably will, be significantly disassociated from the underlying business, at least for a while, if stress and uncertainty hit the market.

With the bond market again under some weakness, with yields rising and areas of uncertainty in geopolitics and high worldwide debt levels, financial stability is worth another look.

The first part of the analysis examines the traditional measures of debt. Of course, these measures of risk analysis are closely tied to the inherent volatility and riskiness of the underlying businesses. That is, what are appropriate debt levels for some businesses are not appropriate for others.

DEBT and INTEREST MEASURES

The ratios I have decided to use are due to, firstly, my understanding of them and secondly, they look at the same issue from slightly different angles, both of which are useful. The ratios are ND/EBITDA, Interest cover (ebit/net interest) and CFO-depn/net interest. If the first measure gets above 2X, I would start to worry; if above 2.5X, then it becomes an issue for me. Not an issue for others; there are plenty of companies carrying much more debt, but I am purposely targeting low risk. The last two ratios I want to see above 4X, but for a rock-solid annuity business, 4X would be more than adequate.

Using the first measure, no significant stock holdings breach the 2X ratio. The closest are CAR Group 1.7X, S&P Global 1.4X, Constellation Software 1.3X, LVMH 1.2X and PNI 1.1X. We will look at the security of earnings in the second part for these, but on the surface, there should be no significant issues of financial stability (like an emergency equity raise) for stocks in the portfolio.

On the coverage ratios, only two holdings, LOV 4.3X and NCK 5.3X, come close. These are retailers and have inherent leverage in their structures. That is not an excuse; retailers should have exceptional management and market position to counter the inherent financial risk and cyclicality. Again, these can hardly be considered significantly risky ratios.

Finally, the outlier here in the analysis is MQG. MQG is a financial, and the ratios are not appropriate. Of course, financial companies, like MQG, are regulated under the financial stability ratios of APRA. MQG continually shows a substantial amount of excess capital. That capital, however, may be needed at some stage, and the inherent leverage of financial companies- assets being several times equity should be considered in any stability analysis. Another case where management needs to be exceptional and conservative.

MEASURES OF EARNINGS STABILITY

The measure I decided to look at here was the volatility of operating income over the last 10 years. Operating income gives a view of the underlying business, not tax or debt. The aim is to see which businesses may suffer earnings weakness while having high leverage, a nasty combination in difficult times.

Up front, the issue with this type of analysis is that we have not had a large recession over the last 10 years. There was a post-C19 slowdown in the US around 2022/3 but hardly nasty. It may well be a falsehood to look at this data, see no real issues, then think all is fine, only for a sharp recession to then eventuate. We can use the analysis to gauge how the companies have performed from a stability point of view, but also weigh if the businesses' cash flows would be vulnerable to a more difficult environment.

When looking at operating income, I have grouped the companies into several buckets. Firstly, those that have had no earnings reversals over the whole 10 years. Every year earnings went higher. Then the next buckets progressively where earnings volatility increases, to lastly where it is most intense, large up-and-down years.  Of course, some of these moves may be stock-specific one-offs, like Government fines, redundancy provisions, etc. I am more interested in where the business shows or may show weakness from tougher economic conditions.

There are 24 stocks considered; about 85% of the total market exposure (the rest are two ETFs, gold, trading cash and some speculative positions). Of those 24, 6 have not seen earnings declines, another 8 have seen one earnings decline; I classify these stocks as rock solid with an important proviso. Another six I would define as modest cyclicals, another three as heavy cyclicals and two as variable. Overall, this appears to be a defensive portfolio, which is what I am aiming for.

Without going through every position, the potential issues that I can identify are as follows.

There is some exposure to the performance of the stock market. HUB, PNI and MQG are all derivatives of the market to some degree. They have done well by gaining share, and that is expected to continue, but the overall portfolio exposure to the market is something I have to monitor and be satisfied with, as when the market falls heavily, it will likely take these stocks down with it.

Another theme exposure is AI capex. AMZN, GOOG, Meta and MSFT are all spending enormous amounts on Dc’s and other capex to capture the value AI will bring. Although we can see signs of results coming through, the stakes are large, and there may well be some bumps along this path. The overall weighting should be considered, especially as there are other AI beneficiaries, TSMC and ASML, in the portfolio. I think it becomes a portfolio weighting question. That is, how much do you want exposed to this story, no matter how positive it may be. Of course, all the hyperscalers have very lucrative other businesses, so they are not solely dependent on these investments from a financial stability aspect, not at this stage anyway.

The two variable companies, FNV and UBER, are very different. FNV is essentially a commodity royalty company with a large bias to gold. I think FNV is the least risky way to play gold outside of bullion itself, but with some growth option. Earnings will bounce around with commodities, as is unavoidable in the commodity space. Being a royalty largely reduces the financial instability. The risk is large M&A at high commodity prices, undermining their net cash financial position. UBER is the ridesharing and delivery marketplace. The question over this business is that it is only recently profitable as the market shares have now settled. The next challenge is the outcome of the marketplace versus AV question, as AVs scale, and who ends up with market power. IMO these become portfolio positioning questions.

The heavy cyclical stocks are TSMC, ASML and NCK. The first two are obviously big beneficiaries from the mainly hyperscaler AI spend. Outstanding companies, leaders in their field; the question is, are they overearning or not? NCK is a retailer and, along with LOV, both very well run, and although gaining share, are exposed to the fickleness of retail demand and are again portfolio-weighting questions.

Finally, PNI is one stock to focus on. The last result was not great, not bad either, but the company is going through a large acquisition phase. The structure, being an investor in underlying associates which are operating businesses, puts one layer between PNI corporate and the cash flows. Under some scenarios, potentially we can see stress in the underlying businesses together with a lack of access to the cash by PNI, causing some issues. Unlikely but still a possibility. Together with some question marks over the current success of a couple of large affiliates, although financial soundness is not in question, it does make PNI an unusual case study.

The reason for doing this work now is to address the issues before the market is hit with adversity and share prices are in free fall. Conviction gets tested, and you need the conviction in place beforehand; otherwise, disaster beckons.

Overall, the financial stability of the portfolio is very strong, and it needs to be. Much of the residual risk can be managed through better portfolio construction, and I have done some work with the help of AI to address some of this risk. Specifically, I like the stock risk-reward, but what weight should it be in the portfolio if financial soundness is to be a favoured factor? I want financial soundness to have a strong presence in the portfolio. That is the next piece of work.