Why this stock investor detests leverage

Pulak Prasad is the founder of Nalanda Capital, a Singapore-based firm that invests in listed Indian equities.

In the early 1990s, he almost always focused on the P&L account – revenue, cost, profit, loss. After many years of investing, he realised that he needed to focus as much on the company’s balance sheet – receivables, inventory, payables, fixed assets, debt.

While not having high leverage makes sense to most, he perches himself on the other side of the pendulum.

A vocal advocate of NO leverage, he walks the talk. In his latest book, he states that more than 90% of his portfolio companies have excess cash. Only 3 businesses out of about 30 in his portfolio have some debt, though quite small – the maximum debt/equity ratio is 0.3.

Here’s what I learnt, specifically with regards to leverage, from reading his book What I Learned About Investing from Darwin.

Survival is much more important than improving short-term RoE and EPS.

There’s no point in improving return on equity by a few percentage points if it compromises on long-term survival.

In the second quarter of 2020, the well-known companies that declared bankruptcy all had a large amount of debt: Gold’s Gym, Hertz, Intelsat, J. Crew, JCPenney, Neiman Marcus, Sur La Table.

The 20 biggest bankruptcies in the U.S. – with Lehman Brothers at the top and LyondellBasell at number 20 – were heavily indebted.

Asian Paints, India’s largest paints business, made news in May 2020 when it announced no layoffs and salary increments to boost employee morale. This happened at a time when India was under lockdown, there was no visibility on when the situation would improve, and every business was witnessing catastrophic declines in revenues and profits.

What is even more commendable is that Asian Paints also was hit. The April – June 2020 quarter saw the company’s revenue decline by 43%, and net profit down 67%, compared to the same period in 2019.

After announcing no layoffs and salary increments, the company went on to sanitize its dealers’ paint shops without charging any fees, offered medical insurance to its painters, gave 45-day extension on payments to its dealers, and announced relief worth more than $5 million to its contractors.

This was possible because of the cash reserves and no debt. In March 2020, the company had $220 million in cash. The CEO pointed out, “we have been debt free for years and are quite comfortably placed even if the uncertainty goes on for the next four or five months”.

The crux of Nalanda's no-debt philosophy:

• The academic claim that companies need to have an “optimal” level of leverage to improve returns, is mathematically true but realistically dangerous.

• A long-term investor in a business, doesn’t want the company to go bankrupt. I can live with a slightly lower RoE and EPS growth, but at least I will live.

• Debt diminishes strategic flexibility and hence long-term value creation. Any constraint that prevents a business from taking calculated strategic bets is undesirable.

• Bad things happen to businesses at remarkably regular intervals. The reason to have cash is not that things can go wrong, but they do go wrong. The macroeconomic environment can become a stiff headwind (GFC), a recession could hit, the industry can suffer a cyclical downturn, a competitor may give discounts or increase spending on advertising, one or more major customers can leave, the company may lose some of its best and key employees to competition, consumer tastes can change, a strategic investment/acquisition may not pay off, regulations can change, and so on.

• Only when financial risk is low, can management focus on mitigating business risks. While worrying about market share loss, low supplier commitment, employee dissatisfaction and competitor aggression, the management doesn’t need to stress of interest payments.

Abbreviations

• P&L: Profit and Loss Account
• RoE: Return on Equity
• EPS: Earning Per Share
• GFC: Global Financial Crisis of 2008

The above information has been taken from What I Learned About Investing from Darwin.

None of the stocks mentioned above are recommendations to buy/sell/hold.