Companies today are facing a multitude of challenges, crises, and macroeconomic headwinds, any one of which on their own is daunting. Last time there was a land war in Europe was 1945. The last global pandemic before Covid-19 was the Hong Kong flu in 1968. Likewise, it’s been over 40 years since we have seen inflation reach the levels we are witnessing today. Other trends are genuinely unprecedented. Coupled with long-term demographic shifts, the ‘Great Resignation’ is leading to severe labour shortages in many industries. Similarly, no previous generation has had to contend with a global climate crisis and the resulting changes required throughout their organizations. The current market environment will continue to test the resilience of companies around the world; as Warren Buffet so eloquently said, “only when the tide goes out do you discover who’s been swimming naked.”
In our opinion, two of the biggest challenges facing companies today are inflation and rising interest rates. After several years of ultra low interest rates and abundant liquidity, central banks are raising rates at the fastest clip since the 1980s. For companies that rely heavily on debt to operate their business, the cost of refinancing that debt at increasingly escalating levels will likely take a meaningful toll given margin compression, increasing difficulty funding capital projects and seizing the opportunities that the current environment presents.
Companies that are in a stronger financial position, however, like those in our portfolio, are more often “self-funding”, using their cash position and strong free cash flow generation to underwrite innovation, make opportunistic bolt-on acquisitions, increase market share, and generally reinforce their sustainable competitive advantages. As highlighted in the charts below, our portfolio companies continue to maintain stronger income generation and balance sheets than the average company in the broader market Index, characterized by a higher operating margin (17% vs 10%), lower financial leverage (2.1x vs 2.8x) and lower net debt to equity (20% vs 55%). We expect this superior financial strength will serve our companies well given the uncertainties in the current market environment.
September 30, 2022
* The Portfolio is the Sprucegrove International Pooled Fund and is intended to serve as a representative example across all portfolios for the purpose of this historical illustration. Actual data points across characteristics will differ by portfolio.
Meanwhile, inflation levels, which have also not been this high since the 1980s, continue to persist even in the face of rapidly rising interest rates. Our portfolio companies are not sitting still during these unprecedented times. They are reinvesting back into their businesses to enable them to better manage the impacts of inflationary pressures, supply chain disruptions and labour shortages. For example, Seria, a leading ‘100 Yen’ store in Japan, is planning to introduce self-checkout kiosks throughout its store network by 2024. Renishaw, a U.K. based science and technology company, has been investing in efficiency improvements which have boosted productivity by 40% while only increasing headcount by 19%.
Meanwhile, other portfolio companies have been able to pass on most or all of their cost pressures to the end customer. Air Liquide, one of the world’s largest industrial gas companies and Fuchs Petrolub, a global lubricants company, both build cost increases into their contracts with customers. Assa Abloy, a leading manufacturer of locks, doors and entrance automation, is leveraging its market leadership to pass on all material cost increases to customers by the end of 2022. Weir Group, an engineering company serving the metals and mining industry, takes advantage of its high aftermarket sales to maintain pricing power.
Finally, supply chain disruptions and increasing labour costs work in the favour of some of our portfolio companies. Fanuc and Omron, which are involved in robotics and industrial automation, continue to see steady demand for their products which help to mitigate rising labour cost pressures while RS Group, a distributor of industrial and electronic products, has seen increased demand as customers shift from ‘just in time’ delivery to security of supply.
Sprucegrove is not sitting still either. The depressed and more volatile market environment, which is a reaction to the risks and pressures highlighted above, creates opportunities. Current conditions have given us an opportunity to add to our position in several existing holdings as well as initiating on new companies, some of whom we have waited for patiently over the years given our valuation discipline. As they have done during past downturns, we expect our portfolio companies to leverage their financial strength and market leadership to further entrench their competitive positions and emerge from the current environment even stronger than before.