Update No. 79 – 28/09/12

The weeks moves in underlying market prices for our holdings saw about a 1/3 of 1% rise in EGP, which was better than the nearly ½ of 1% drop experienced by our benchmark.  As I touched on last week, a full 18 months of operation has passed for EGP Fund No. 1 Pty Ltd, and fellow investors have enjoyed a better than 1% per month advantage over our benchmark.

This week I wanted to soap-box about corporate debt.  I hate corporate debt.  It has been killing corporations for as long as they have been borrowing.  Inevitably at the very time when you need their support, bankers tend to make it unavailable.  I understand risk-takers (CEO’s and company founders often fall in this category) tend to be happy to live close to the edge, but I just don’t see that it’s necessary.  Many great fortunes have been built with the use of debt; Rockefeller grew Standard Oil by borrowing & doubling down time and again.  I wrote the bones of this post a fortnight ago after Fortescue Metals (FMG) were hammered when it came to light they had asked lenders for 12 months grace on the covenants attached to their debt.  This (naturally) indicated to the market that whatever those covenants were, they must have been somewhere near breach.

I really struggle to understand why FMG has pushed so hard, a more relaxed expansion would have been so much lower risk, and would probably avoided one of Australia’s largest companies trading on a day to day basis like a ‘penny stock’.  Pay a small dividend to shareholders and use the remaining cash to fund expansion, perhaps with some modest borrowings. I appreciate FMG are trying to maximise profit before substantial new capacity comes to market, but Aesop’s ‘The Tortoise and the Hare’ aptly describes the usual outcome in business (measured over the full race) – that is, when you race steadily & methodically toward your goal, success is more likely than when you rush.

The best businesses are those that generate good profits and can compound the majority of their excess capital at above average rates (obviously returning any that cannot be used at these good rates to shareholders).  Businesses that need owners to continually contribute new capital are rarely good businesses; likewise businesses that need to borrow heavily to generate suitable returns are usually poor investment choices.

I have mentioned this in these pages before, but the best way to succeed in investment is to start young and invest consistently.  At a personal level, the use of some (a modest amount that is – only if borrowed at a low price/rate) debt is very good; there are some advantages to this idea I have likewise touched on.

The important thing is to borrow modestly and invest carefully.  Returning to FMG, based on FY2012 result, they have borrowed about 7 times their current NPAT.  As a general rule, I avoid companies carrying corporate debt completely (I do occasionally make exceptions), but my preferred rule of thumb is that no more than 3 years free cash flow should be required to extinguish all debt, if that is not the case some other unusually compelling situation would need to prevail to entice my investment interest (most probably extremely high confidence about higher future profits or extremely high confidence in underlying asset values).

My preference is general avoidance of corporate debt, coupled with above average returns and an extremely long life.  Irving Kahn is an example to us all of the 3^rd point, he is the world’s oldest active stockbroker at 106 years.  If I can get the same sort of career longevity and combine it with what I think is an eminently achievable 10% per annum after tax return, every dollar I have invested today will be worth about $790.  Should I manage a more impressive 15%, todays dollar is potentially worth $17,750 to 106 year old version of myself – Tony Hansen 28/09/12.

EGP Fund No. 1 Pty Ltd. Up by 12.33%, leading the benchmark by 3.49% since July 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 15.7%, leading the benchmark by 18.25% all-time (April 1^st 2011).