Written by Connor Barth, CFA, this article originally appeared on CWB Wealth's Insights blog. Connor is a Senior Research Analyst for CWB’s Canadian equity portfolios. A graduate of the University of Alberta with a degree in mechanical engineering, he has worked in the financial industry for over half a decade.
A rockstar in any galaxy
Canadian astronaut, Chris Hadfield, wrote an amazing book called An Astronaut’s Guide to Life on Earth. He walks through his life journey and describes what going into space taught him about ingenuity, determination, and expecting the unexpected. The man has an extremely long and impressive list of achievements, and it seems like he can do pretty much anything, including play the guitar amongst – and for – the stars.
Rocket man
Chris’ fame spiked after his poignant rendition of Space Oddity by David Bowie went viral. What made this unique wasn’t how well he performed it, but where he performed it – the International Space Station. It’s worth a view if you haven’t already seen it.
While penning his book back on Earth, the space musician explained in an interview with National Public Radio (NPR), a non-profit media organization, how he thought it could go at an upcoming Elton John concert:
…And I thought the odds were extremely small, but they were convinced that we were going to meet Elton John...I went, OK, what’s the worst thing that could happen? The worst thing that could happen would be that I meet Elton John, and Elton John and I are talking, and he finds out that not only am I an astronaut, but maybe he loves astronauts, and he wants the astronaut to come up onstage.
What would be the only thing that might happen if he finds out that an astronaut who’s up on stage with him plays guitar. What song could they play together? Rocket Man. So that afternoon I sat down and learned Rocket Man. In the slim chance that the worst-case scenario were to happen, I wanted to be prepared.
In this scenario, Chris meets Elton and, in typical show business fashion, is pulled up on stage to perform Rocket Man. The audience is ecstatic, with enough energy in the stadium to launch a rocket.
It didn’t quite pan out that way. Chris did in fact meet Elton backstage, but no duet was performed. Rather, he remained firmly on the ground in the audience where he enjoyed a top-notch performance.
This story, among many others within his book, illustrates Chris’s unique ability to evaluate risk and prepare for extremely low-probability outcomes. This incredibly valuable skill comes from his extensive training as an astronaut where preparation, expertise, wherewithal and cool-headed temperament are all hard-earned table stakes. Astronauts need to be able to effectively manage a wide range of worst-case scenarios because a small error or a slight hesitation 400+ kms above Earth’s surface can mean life or death.
I’m not sure how often business executives deal with life-or-death scenarios or get pulled up on stage to perform I Get Money with rapper 50 Cent. But they do have to prepare for a variety of worst-case scenarios.
Operating in complex environments, business leaders regularly face overlapping risks, macro-economic conditions, and disruptions that can be unpredictable and difficult to identify beforehand. The sudden onset and transformative effects of COVID-19, and subsequent impacts of lockdowns, clearly highlighted these challenges.
So, how do executives prepare for events like these?
Mitigating risk with appropriate leverage
Like Chris, high-quality management teams recognize that worst-case scenarios will arise from time to time. They also understand that one of the best ways to maneuver through these environments is to maintain a healthy and robust balance sheet. An appropriate amount of leverage can provide a company with more flexibility during economic downturns, reduce their reliance on external capital in bad environments, and put them in a strong competitive position through the eventual recovery.
Boyd Group Services Inc. (BYD), a publicly traded auto collision repair specialist, exemplifies the strengths of resilient leverage. Their two largest competitors are privately-owned businesses with significantly more debt on their balance sheets than Boyd. In fact, this degree of leverage (i.e. money borrowed to grow the business) approached those of some utility companies, whose revenue streams are much more predictable. Leveraged in this way, the two companies outperformed Boyd on returns on equity and other growth measures over the 10+ year bull market leading up to COVID-19.
However, as the number of accidents sharply fell during lockdowns – thereby dramatically reducing demand for collision repair – their balance sheets became veritable anchors as they struggled to service their debt. Boyd, on the other hand, navigated COVID-19 comparatively well. They managed through 2020/2021 much better than their competitors. Their strong balance sheet meant they avoided the need to raise dilutive capital and have mostly recovered to pre-pandemic operating metrics. We believe that the company is now the only major consolidator in town and has a great opportunity to accelerate their performance and expand their operations through highly accretive acquisitions. Their two main competitors, meanwhile, are still being slowed down by their debt anchors.
Leverage is an extremely important metric that we analyze within our research process. Although some companies can afford higher debt levels, we’re much more comfortable with businesses that have appropriate leverage and operate with healthy balance sheets.
We also look for management teams that approach risk management like Chris Hadfield. That is, leaders who are experienced in risk management, prepare for unlikely worst-case scenarios, and structure their businesses to weather a wide range of market conditions and shocks.
It’s not often that one of our portfolio companies is pulled up on stage (or flies on the International Space Station, for that matter). But we sleep comfortably knowing that the management teams we invest in are prepared for unseen storms and deliver a top-notch performance when the sky clears.
Sources: FactSet, Bloomberg, NPR
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