Shareholder Letter: Beware the Macro fallacy
by Dirk Markus
This is a challenging time for investors. There are two particular issues that are front of mind here:
· Brexit and whether it’s a disaster waiting to happen; and
· the possibility of a global recession.
To assess what these factors mean for AURELIUS Equity Opportunities (AEO), we have to look at two things: firstly, our ability to execute attractive new transactions against this backdrop, and secondly, how these factors might impact the development of our existing portfolio of companies.
Transacting in the UK – finding the hidden gems amid Brexiphobia
As you may have seen, AEO has announced its acquisition of two businesses in the UK market this month - BT Fleet Solutions and parts of the Armstrong ceilings business.
There has been some scepticism from our shareholders around these deals, with many of you questioning the rationale behind our investment in the UK market at this point in time.
Whilst it’s true that macroeconomic factors such as Brexit will undoubtedly have severe implications for the British economy overall, it does not mean that the region should be off limits or that it can’t still present several compelling investment opportunities for us as a special situations investor.
It is our job to look past these macroeconomic factors and to focus on the micro issues at play within each company. It is these factors which really matter when it comes to assessing the individual prospects of a particular business.
Opportunity in uncertainty
In fact, the period of uncertainty and disruption that has been triggered by Brexit has provided a unique investment environment for investors like AEO, who are in a position to harness it.
We seek deals that can offer two things: a business with decent, improvable fundamentals, and an attractive deal price. In exploring these two factors, we can see that the uncertainty created by the ongoing Brexit discussions has, in fact, been working in our favour.
Brexit has severely depressed the sterling, which has had a positive impact on British exporters. Take the Armstrong ceilings businesses, for example, which manufacture suspended ceilings products in two plants based in the UK. This means that the company pays its main input costs – labour, materials, electricity, gas etc. - in sterling. The ceiling tiles are going on to be sold in a range of countries across Europe, many of which have the Euro as their currency.
So, for this business, a hard Brexit, which will likely lead to a (further) weakening of the pound, will result in improved profit margins.
“But, what about import duties? Surely those will be detrimental to UK-based exporters in the future?“ I can hear you ask. This is an important point, but even in a hard Brexit scenario, we will see most-favoured nation clauses implemented which will result in import duties of a few percentage points, at most. These amounts are unlikely to have a significant impact on business plans and will be more than over-compensated for by the “sterling effect“, mentioned previously.
So what about attractive deal terms? The very same macro factors that are making investors nervous also compel sellers to part from their struggling businesses at prices attractive to buyers.
The coming recession – a flu epidemic?
One of the metaphors I have routinely used in the past is that of AEO being a hospital for sick businesses. An investor asked me the other day what a recession would mean for our portfolio of companies in the UK. Would we expect a large number of companies to get into trouble? I.e. Would a recession act as a flu epidemic that would potentially kill off those patients in our hospital weakened by other diseases?
A global recession would certainly impact our portfolio companies. However, we would expect the impact of macroeconomic factors to be much smaller on the portfolio of companies in our “hospital“ than on other “well performing” businesses.
Again, it’s about the micro factors trumping the macro. At AEO, when we acquire businesses, they are typically not very profitable with profit margins usually ranging from 0-2% of EBITDA. Once we have bought a new business, our taskforce of operational experts will support management in realigning the business to get it back on track, typically to an EBIDTA margin of 8-10% after 18 to 24 months. We do this by addressing both the cost base and the revenue streams. On average, we see a performance improvement of 700 basis points.
Now, say we assume a recession would reduce overall GDP growth from 1.5% to -0.5%, so a 2% decrease in output. Further assuming a 30% gross margin, this would mean a deterioration of a company‘s EBITDA by 60 basis points. Not nice, but not a disaster either, particularly when it compares to a 700 basis point improvement in underlying performance.
So, the very fact that the business is not yet perfect means that the company-specific or micro improvement efforts far outweigh the impact that a recession might have.
Making the most of opportunities
At AEO, the micro factors will always play an integral role in how we assess opportunities for our business, and we will continue to invest in regions that might be temporarily out of fashion such as the UK if a deal makes sense to us based on these assessments.
We have a strong portfolio of companies operating in the UK and continue to work hard with them to deliver the operational changes they need to help them weather the external and internal challenges they are facing, positioning them for growth going forward.
As John F Kennedy once observed: “The Chinese use two brush strokes to write the word 'crisis.' One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger - but recognise the opportunity.” We certainly recognise the opportunity available to us in these times of disruption and uncertainty and have every intention of making the most of it.