The Scottish Oriental Smaller Companies (SST) team is concerned that unorthodox monetary policies that were put in place in the wake of the global financial crisis have created a culture where investors and business owners assume that ‘debt is wonderful’.
In the trust’s August update, the team pointed out that low interest rates and quantitative easing (money printing) have caused debt to become much cheaper for governments and companies to service, which has had profound repercussions.
‘The wave of cheap money unleashed by these policies resulted in asset prices being bid up with the opportunity available to fund the purchase of assets with borrowed money at historic low interest rates,’ the managers noted.
This assumption could create problems if companies gear up on the belief that they are creating an ‘optimal capital structure’. In fact, this could ultimately reduce their ability to take advantage of opportunities when they arise, as well as increasing risk if there are any unforeseen setbacks.
With this in mind, the Asian small companies team – led by Vinay Agarwal and Wee-Li Hee – has reviewed the trust’s debt arrangements, alongside the debt levels of companies held in the portfolio. Agarwal is Citywire AAA-rated for his performance running the First State Indian Subcontinent open-ended fund.
Paying down debt
Investment trust managers draw on debt – or gearing – in order to put extra cash to work when they believe valuations look attractive. The Scottish Oriental team briefly utilised their debt facility in 2012 but have since been net cash.
‘The rationale for taking on debt was that during the global financial crisis (when stocks were cheap and it perhaps would have been an advantage to have had the flexibility to gear Scottish Oriental) banks were most unwilling to lend money.
‘Therefore we concluded that it was best to draw down debt in more benign times to have available as "dry powder" - should markets weaken and stocks become cheap. We are still waiting for this to happen,’ the team noted.
The problem that Agarwal (pictured below) and Hee face today is that markets continue to creep higher and stocks look expensive, which means a significant correction would need to take place before he would consider utilising the debt facility.
‘We also have high levels of cash reserves as we are finding it a challenge to buy stocks at reasonable valuations. We have therefore already increased cash available to take advantage of any weakness in markets,’ the team added.
As a result, the team and board have decided to repay a £20 million loan that was due in August 2019, which had an interest rate of 3.135%.
‘We realised that should markets fall sharply, say perhaps in 2018, and we saw a repeat of the tight liquidity conditions from the Global Financial Crisis we would be nervous about utilising the debt unless we could be certain of extending it which would be far from guaranteed in such a scenario,’ they added.
Nevertheless, the team remains open to using debt on a tactical basis and said it would like to hear shareholders’ views on this.
Looking under the bonnet
At a stock level, the team likes companies which use their cash flows to pay down debt. They take the view that ‘debt should be used carefully’.
After carrying out a review of the debt levels of Scottish Oriental’s investments, they concluded: ‘Whilst by no means bullet-proofed, we feel the balance sheets of Scottish Oriental's holdings are in pretty good shape.’
Out of 60 stocks in the portfolio, 32 have net cash on their balance sheets, while the remaining 28 had average gearing of 58%. The team also looked at interest cover, which measures a company's ability to meet its interest payments.
It noted that Indian retailer Shoppers Stop came out the worst on this metric with interest cover of only 0.3 times – well below an average of 5 across the portfolio. This shows that its profits before interest and tax do not cover the interest payments on its debt.
‘It is loss-making. We have only just purchased this company as we see a return to profitability and the company generating sufficient cash flows in due course to both service and repay its debt,’ the team explained.
HeidelbergCement India also sits in the group of companies with sub-5 interest cover, with debt repayments covered 2.3 times by earnings.
‘The Heidelberg Group have done a tremendous job turning around what had been an over-leveraged and operationally weak cement company since gaining control of it. We expect strong profit growth here making debt servicing much less of a concern,’ they explained.
During the first half of 2017, the team said portfolio activity had been higher than expected, with 12 new positions initiated and 15 disposed. This reflects their focus on profit-taking, alongside moving out of stocks where they see little growth.
Hong Kong-based restaurant operator Fairwood Holdings features among the new additions to Scottish Oriental, while Chinese tech stock Sunny Optical was sold for a healthy profit.
Over the five years to 10 August, shareholders in Scottish Oriental have seen its share price rise by 78.2%, slightly lagging 80.6% by the average fund in the Association of Investment Companies’ Asia Pacific – Excluding Japan sector. It currently trades at a discount to net asset value of 11.6%, lower than a 7.2% discount by the sector average.