Stock Talk | Taking a look at capital management
Everyone loves a capital raise. In recent times a number of listed property companies have raised equity capital. The table below shows a list of these companies and the amount raised:
These actions, across a very short period, tipped almost $4 billion of new equity into the listed property market. The fact that each of these parties decided to undertake a similar action at a similar time is unlikely to be a coincidence. The reason for this will be discussed later in the article, but first, it is worth covering the different types of capital management that companies can choose to undertake.
Capital management refers to the management of both debt and equity balances, with the goal of achieving the best possible risk adjusted return for the entity. Whilst managing the debt side of this equation is essential, the focus of this discussion will be on how companies manage their equity. Effectively, there are three major actions (or non-actions) a company can take with regards to managing their equity:
- Undertake an equity raising – Make the business larger (assuming a stable capital structure) by issuing new shares for fresh capital;
- Do nothing – Keep the business the same size (commonly the best option), keeping the share count stable; or
- Undertake a share buyback – Make the business smaller (assuming a stable capital structure) by buying and cancelling shares, reducing the number of outstanding shares.
Buybacks – How much would you pay for $1?
Buybacks may have a negative stigma to some as they do make a company smaller; however, at certain times, undertaking a buyback can be one of the simplest ways to create value for shareholders. Looking at a simplified example may be instructive.
Imagine you and two friends each have an equal share of a company. This company owns a building worth $10 million and $5 million of cash, for a total of $15 million in assets. Clearly, your share of this company is worth $5 million ($15m ÷ 3).
Now suppose one of your friends (the not so clever one) offers to sell their stake back to the company for $3 million. Should the company accept, its assets will comprise of $2m in cash and the $10 million building ($12 million total), so the company is smaller.
Despite the reduced size, you now share it 50/50, so your stake is worth $6 million. By accepting your ‘not so smart’ friend’s offer, instantly and with no risk, you and your ‘smarter’ friend have made yourselves $1 million each, or received a 20% return ($5m - $6m). To put it another way, you have been able to buy a dollar for 80 cents.
Sunland Group - a real life example
The example above may seem obvious, but it is astounding how many companies do not take the opportunity to buy $1 for 80 cents (or less) when presented with the opportunity. One company that has taken that opportunity is Sunland Group (SDG). SDG is a residential property developer with projects along the east coast of Australia.
An overly simplistic proxy for the value of a property developer like SDG, is its tangible book value, as due to accounting practices, the property component of book value is reflected at the lower of its historical cost, or its net realisable value.
As you can see in the chart below, over the past ten years, SDG has bought back more than 180 million of the 320 million shares that were outstanding in June 2009.
As a result of these buybacks, one SDG share owns approximately 2.3 times more of SDG than it would have had in the absence of the buyback. To demonstrate how strong an investment this has been, the slightly more than $160 million spent periodically on buybacks over the last ten years would have to be worth more than $450 million today to have created as much value for investors.
SDG’s wonderful capital management is not surprising when you consider the incentives of the decision makers. The controlling family owns more than 40% of the company and takes one of the smallest remuneration packages of any management team of a real estate company of its size.
Many other companies are more reticent to buy back shares when the opportunity presents itself. This can, at least in part, be put down to the fact that it is not in the best interests of many management teams to do so, even if it is in the best interests of shareholders. This is known as the agency problem, as shareholders (the principals) grant management teams (the agents) the authority to run the business on their behalf.
At times the interests of the principals and the agents may diverge. In many cases, management teams do not own a significant quantity of shares, particularly in comparison to their salaries. It tends to be in the interests of management teams to grow the company, as running a larger company correlates to higher salaries and greater prestige. In some cases, there may be sensible reasons (such as reinvestment opportunities, or debt management) that can explain why companies do not undertake buybacks when it seems obvious to do so.
Public vs private
The case for undertaking effective buybacks is clear, so when does it make sense to do the opposite and raise capital?
The first possible reason is that the new capital can be used in a way that can achieve outsized returns.
This is a high hurdle to overcome in a lot of cases, due to the large transaction costs incurred to acquire property in this manner, including stamp duty and equity raising costs.
The other scenario in which raising equity makes sense is when the listed (public) property market and direct (private) property market disagree on the value of assets. The shares of a listed real estate company may, from time to time, trade at a large premium to their book value, which can be thought of (very roughly) as private market valuations.
When this is the case, it may indicate that public market investors assign more value to the property than private market investors. In this case, it is perfectly logical that private real estate owners will sell their properties to public real estate companies, who may raise equity to pay for them.
Back to today
As was said at the start, it is not a coincidence that so many companies have raised equity recently. Each of these companies had strong share price performance in recent times and were trading at reasonable premiums to their book values. Furthermore, management teams may also be less hesitant to raise equity when it makes sense, than to buy back stock when it makes sense, as it is more likely to present a win-win for both shareholders and themselves.
Assessing the quality of a company’s capital management is a crucial part of the investment process, and this assessment can be difficult to apply to a standard valuation framework. As such, Phoenix assigns an agency score to each company in its investment universe based on its capital allocation, reinvestment opportunities and management’s alignment of interests with shareholders.
Phoenix actively considers this agency score when making investment decisions. Times such as the June quarter, when several companies make active capital management decisions, demonstrate the importance of this part of the investment process.