Insight Memo II - Resilience

Subject:      Goodbody Global Leaders Fund

Author:       Shane Butler, Fund Manager

                        Goodbody Asset Management

Date:          17th June 2020

Title:          Own the Best – Not the Rest

This is the second in our series of Insight Memos that examine what we believe are the three defining characteristics of Global Leaders. In the first Insight Memo, we provided a broad overview of the strategy of the Fund – ‘Own the Best, Not the Rest’ – and identified the three key characteristics of Resilience, Adaptability, and Execution. In this Insight Memo, we detail how we view Resilience from an investment perspective.

The one certainty in the world is uncertainty. Nobody knows what the future holds. It’s rarely the known unknowns – the risks cited in daily headlines – that cause the most harm but rather the unknown unknowns. It is the unforeseeable, low probability, high impactful events like Covid-19 that really have a significant impact.  

The unknown unknowns are clearly impossible to predict. Crises will continue to happen; we just don’t know what or when. However, the one thing we can analyse with some degree of certainty is whether one company is more fragile than another should an event happen. It is much easier to understand whether a company can be harmed by volatility than it is to forecast rare events. Fragility is somewhat measurable whereas the magnitude and timing of rare events is not. Rather than trying to figure out what bad events may happen, we try to focus on understanding the Resilience of a business in the face of future adversities that are ultimately inevitable.

A simple framework we can use to assess the Resilience of a business is through the three lenses of leverage:

(1) Financial leverage – the amount of debt on a company’s balance sheet.

(2) Operational leverage – the level of fixed costs in a business.

(3) Cyclical leverage – the sensitivity of a business to the broad economic cycle.

Financial leverage (the amount of debt used by a company) is the simplest, but perhaps the most important, indicator of a company’s Resilience. If a company has ample cash in the bank, they generally do not need to know with precision which event will cause potential difficulties. A cash-rich balance sheet essentially acts as a shock absorber in the face of unforeseeable events. Conversely, companies carrying significant debt loads tend to find themselves in the opposite situation – the fragility of their balance sheets leave them highly sensitive to the path of future events. An unforeseeable situation like Covid-19 could meaningfully hinder a company’s cash flow, limiting its ability to make debt repayments, and potentially jeopardising its credit rating at the exact moment when they most need access to capital market funding. High debt levels leave a company acutely sensitive to the path of future events, increasing the requirement for them to make more, and more accurate, predictions about the future. One thing we can predict is that those reliant on predictions are more fragile than those who are not. In short, cash provides flexibility whereas debt causes fragility.

Operational leverage is another lens through which we can assess the Resilience of a company. Operational leverage refers to the level of fixed costs in a business. Companies with higher levels of fixed costs tend to have more volatile earnings streams. Airlines are the classic example of a business with a high fixed cost structure – the cost of flying a plane 50 percent full or 100 percent full is essentially the same. If the demand for flying turns down, airlines cannot easily vary their cost structure – their revenues decline but their costs remain largely the same and profits can quickly turn to losses. Operational leverage is generally considered an attractive attribute during periods of healthy demand as it can lead to rapid profit growth. The trade-off, however, is potentially crippling during periods of unexpected weakness as a company’s profits can quickly disappear. In our experience, Resilience is best measured during periods of adversity. Ultimately, the weakness of high operational leverage is exposed and magnified during downturns.

A third lens to assess Resilience is cyclical leverage – a measure of how reliant a company is on the level and direction of broad economic growth for its success. To be clear, the growth of all companies (Global Leaders included) is somewhat related to the strength of the broad economy. However, the growth of genuine Global Leaders is (at least to an extent) within their own control. They tend to be the enablers of durable growth trends rather than beneficiaries of those trends. Resilient companies tend to have a degree of control over their future. Fragile companies, however, are often purely reliant on the rising tide of a strong economy to buoy their success.  

In summary, unforeseeable, high-impact negative events will continue to occur. Rather than trying to forecast and avoid them, we try to accept their future occurrence and aim to only own companies we believe can be Resilient during such challenging times. Central to this is having a clear understanding of the types of business models we want to own but, much more importantly, the types of business models we want to avoid. In short, we do not want to own companies operating in the triple leverage danger zone of high financial leverage, high operational leverage, and high cyclical leverage. Banks, auto manufacturers, and airlines – industries characterised by serial bankruptcies – are examples of business models that tend to operate within this triple leverage danger zone. These types of companies tend not to have the financial resources required to withstand challenging circumstances. Rather than merely surviving bad times, Resilient companies may have the flexibility to capitalise and thrive from extreme events. Examining Resilience is a key step that helps us to implement the strategy of the Goodbody Global Leaders Fund – ‘Own the Best, Not the Rest’. 

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