The Liquidity Cycle and the Value of Scarcity
– David Wanis, May 2021
Companies delivering high growth, funded from internally generated cash flows are rare – and in small caps you often must choose either growth or cash flow. When external market liquidity – from government deficits, central banks, or investor enthusiasm – is abundant, no one cares about internal corporate liquidity. Only growth matters. Should external liquidity become scarce again – and history shows it is cyclical even if we have not seen it for a while – the scarcity of internally liquid small companies should become apparent and valued.
Internal Cashflow and External Liquidity
When we managed a microcap fund in a previous life, one of our guiding principles was the interaction between internal company generated and external market provided liquidity. Through a liquidity cycle it became clear few people care if a microcap goes broke. If a capital raising from the public market is the only thing standing between shareholders and a receiver, many microcap investors find out the hard way (as we did) there is not enough interest in keeping the company going. Internal liquidity is about survival. Ensuring you do not interrupt the process of compounding by multiplying your returns by zero.
This is not always the case in large caps. There will almost always be a market for providing capital to an ASX100 company. They are well known, held in hundreds of portfolios and usually businesses worth saving from receivership through recapitalisation at an attractive price. Once again, small caps are different.
Except for about six weeks during 2020 when the pandemic gripped markets, we have been in an expanding liquidity cycle traced back to the end of Fed tightening in late 2018. Expanding liquidity is positive for companies with external financing needs. This tends to end in one of two ways, i) external liquidity conditions are tightened by the Fed, RBA, government deficits, bank credit standards, investor sentiment etc, or ii) creation of new companies with a deficit of internal liquidity soak up all available excess market liquidity. The market usually focuses on the first, and the catalyst may be inflation (as we discussed last month) – or it may be something else entirely unexpected. New issue supply to soak up the demand for companies with external financing needs is a feature of every cycle and industrious investment bankers can exhaust most surplus liquidity given enough time. The quality hurdle for these new companies is at historically low levels – indeed SPACs are an indication the demand for something (anything!) to buy has overwhelmed even the lowest hurdle of being able to IPO an existing company.
At some point the new issuance, and the repeated follow-on issuance from these companies – required because they rarely raise enough cash in an IPO to make it to the stage of being self-funding – will exhaust investors. Not while share prices are rocketing of course. But eventually when more dollars need to be committed and share prices are not giving the previous sugar hit, investors may start to wonder why they are still playing a game reliant on realising early when the music has stopped.
We of course have no idea when external liquidity will change, if enough cash burning companies have been created to soak up what liquidity there is available and if the cycle ends this month, quarter, or year.
Our own burned fingers have taught us this is a game we would rather not play. When the liquidity cycle turns, the scarcity of quality small companies generating internal cash flow to fund their growth will likely be valued, rather than overlooked, by the market.
Liquidity by Example – CSR Ltd
We look at the liquidity of our portfolio holdings a few ways. Free cash generation by the business. Returns generated on capital employed (and returns on incremental capital retained). Gross debt in the business – our time working with credit investors has made us skeptical of period end cash balances and the use of net debt metrics. Near term balance sheet liquidity. Dividends paid out. Share buybacks completed.
Companies showing opposite attributes provokes caution. Companies with years of external financing needs in front of them. High reliance on debt (often a reflection of poor historic cash generation). Money flowing from shareholders to the company rather than the other way around, evidenced by the most consistent growth achievement being the share count rather than any free cashflow or dividend per share number.
It is far harder than the market assumes to create a sustainable, growing and cash generative company. Most small caps will fail to achieve this. Right now, the market is assuming a level of commercial success (both in frequency and magnitude) completely unsupported by history.
During May, CSR Ltd – a significant holding in our fund today and since inception – reported their full year result. A stand-out feature was the earnings (EBIT) of the building products division – higher margins and higher return on funds employed (>20%) were delivered despite sales still declining y/y from the tail end of the last cycle. That is hard to do and bodes well for earnings as the increase in building activity flows through from next year. One of their key property holdings in Western Sydney (represented nowhere in the financial accounts) was re-valued at A$900m – up from A$500m two years ago. In talking to and meeting with residential property market participants in the past few months, the supply of immediately available residential land is almost exhausted, and land prices are headed higher. This one asset is worth around 30% of the current CSR market cap – likely more once realised in a few years’ time – and is not the only property asset in the portfolio missing from the balance sheet. CSR is a business with no debt, strong free cash flow, significant value in unreported land assets and facing a pickup in revenue growth and expanding margins and returns over the next few years.