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At a wedding recently I heard a best man’s speech that was the result of him searching the internet for good best man jokes. Or maybe he had used ChatGPT. Either way, it was dreadful.
Listening to it in some pain — “even the cake was in tiers” — I was reminded how I sometimes feel at investor conferences as fund managers explain their investment process.
They deliver their pronouncements like priests revealing hidden mysteries from scripture to the privileged few. But the speech is the same as umpteen others I have heard. It goes like this: “We always buy strong, cash-generative companies that have robust balance sheets, earnings growth and good market positions.”
I wish for once someone would say: “We are not afraid to buy companies that are burning cash and therefore have weakening balance sheets to the point that some may run out of money and will need to raise fresh capital or go bust.”
The truth is that both the best and the worst future investments fall into this category. The best-performing share in the FTSE 100 this year is one of our holdings, Rolls-Royce: the share price is up more than 127 per cent.
Yet in January the new chief executive, Tufan Erginbilgiç, was warning staff and investors that the company was “a burning platform”. Rolls-Royce had been consuming cash and had not been making a reasonable return on invested capital.
A transformation programme was put in place that is leading to efficiencies and optimisation. Spending on non-core projects has been cut. Maintenance contracts are being renegotiated.
Outside events are helping, with the number of air miles flown globally returning to pre-Covid levels faster than expected. But an improving company makes its own luck, too. When a manufacturer successfully attacks costs at the same time as sales performance improves, the operational leverage leads to substantial margin expansion.
In the case of Rolls-Royce it has meant underlying operating profits for the first six months of this year hitting £673mn — double what analysts expected — and an operating margin soaring from 3.4 per cent a year earlier to 12.4 per cent.
Those seeking only companies with strong cash flows have missed out. A look at Rolls-Royce’s share register shows it has been US investment managers with a value bent that have been large beneficiaries of the share price rise. Their analysis looked beyond the recent operating numbers to examine the quality of the product and the pipeline of sustainable jet engines Rolls-Royce was developing.
I believe a well-balanced portfolio can include — as well as good cash generators — companies that for various reasons are burning cash. It is for them that the stock market exists. Its role is to provide equity risk capital.
Nowhere is this more obvious than among smaller companies where the chances grow that you may receive a “capital raising” communication at some point, inviting you to stump up more cash or see your shares watered down.
There may be all sorts of reasons for this. The example I remember most vividly was back in 2001, just after two planes crashed into the Twin Towers in New York. Claims on insurers were huge — from the plane owners, the building owners and the companies with operations in those iconic skyscrapers. There was a legal wrangle over whether the two attacks represented two events — effectively doubling the cover for many of the insured. Our holding, the then small insurer, Hiscox, came to the market twice — in 2001 and 2002 — to raise about £164mn to restore its balance sheet.
In a fundraising rights issue what normally happens is that a new portion of shares is issued at a discount to the price of existing shares (typically about 20-25 per cent). Existing investors are usually offered the chance to buy those shares in proportion to their holding (and sometimes any leftovers from people who decline). As a consequence of the share issuance, the value of individual shares is watered down — but, in theory, the market capitalisation of the company should increase.
Hiscox grew rapidly afterwards. It was able to write new business at very attractive rates as others were withdrawing from the market because they had insufficient capital to operate. The rights issue shares were £1.20 and £1.65. Today Hiscox shares trade at more than £10. Taking up that issue paid off handsomely for us.
It does not always work like that. Two months after Covid closed its pubs, Wetherspoons came to the market in an usual emergency fundraising — going straight to institutions to try to raise £141mn from selling about 15mn shares at £9. Lessons and disciplines can be learnt in adversity and competition reduced, so when the pressure is relieved the company is well positioned to prosper.
That was our thinking. We participated and regretted it, selling the shares later at a loss. Wetherspoons trades at about £7 today. That fundraising provided vital capital for the business — but not returns for shareholders.
Sometimes a company will raise capital for an acquisition. In 2006 speciality chemicals company Croda issued 12.38mn shares at about £5 to help it fund the £410mn purchase of rival Uniqema. The new business was a perfect fit. We participated. Today Croda’s shares are worth nearer £50.
In the Aim market fundraising is usually a result of early stage companies needing capital to move from prototype to production or to build plants to expand production. We are seeing this with alternative energy companies such as AFC, ITM and Ceres.
But when looking at a company burning cash or raising capital, we ask a number of questions:
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Is there a good reason for the cash burn — is this an investment that will pay off soon?
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Is it because of a short-term crisis — will it come out stronger from this, the fittest survivor in a decimated market?
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Is there a good business there, trapped by events that will change?
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Are we confident in management? Often rights issues come with new management and are an opportunity for a review of costs and a necessary reorganisation and refocusing.
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Is the need for spending and raising fresh cash clearly articulated?
If we are not happy with any of these answers it may be a moment not just to decline the invitation to throw good money after bad but to quit and run.
Investing in companies like this involves risk. That risk, though never eliminated, can be mitigated by diversification and good research. When I look back on my career, most of the companies that have generated the best returns in my portfolios have been those that at purchase were investing well above the cash that came from their operations. In uncertainty often lies the best rewards.
James Henderson is co-manager of the Henderson Opportunities Trust, Law Debenture and Lowland Investment Company
