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During the last several years of my career, my round-trip work/home train commute was ~2 hours. At 5 days/week, that would have been 10 hours/week where I could have read material to improve my knowledge.
In hindsight, I did not use my time wisely.
- On my morning commute, I would be sound asleep within minutes after boarding the train.
- I would be asleep 50% - 60% of the time on my commute home.
I tried on several occasions to read but, clearly, I failed to master my mind and defy the odds.
Following my retirement from the workforce in May 2016, I have the luxury of being able to do pretty much what I want to do and when I want to do it; I can now read MUCH more.
In my recent The Illusion of Wealth: The Cost of Trading Time For Money post, I list 5 books I am currently reading. I have subsequently completed Can’t Hurt Me – Master Your Mind and Defy the Odds by David Goggins and have started reading Capital Allocation – Principles, Strategies, and Processes for Creating Long-Term Shareholder Value by David R. Giroux.
I like to conduct my own investment research and analysis. This means pouring through company websites, SEC Filings, industry related materials, etc.. I am particularly interested in how companies optimize capital allocation for long-term shareholder value creation. The subject matter of Giroux’s book, therefore, prompted me to read it.
Key Message
Giroux argues that boards of directors should consider all available alternatives and prioritize deploying capital at the highest possible returns on a risk-adjusted basis.
The book covers a significant amount of material on the matter of capital allocation. Buffett’s and Munger’s two rules of investing, however, are always on my mind.
- Rule #1: Don’t lose money.
- Rule #2: Don’t forget rule #1.
This is why Chapter 4 – Five Stress Test Rules For Downturns in Giroux’s book immediately attracted my attention.
Five Stress Test Rules For Downturns
To protect a company and its long-term shareholders, Giroux lays out 5 stress test rules every management team and board should follow. In order of importance, they are:
- Don’t go bankrupt
- Don’t issue equity from a point of weakness
- Don’t cut the dividend
- If the firm is investment-grade, remain so throughout any downturn
- Don’t lose financial flexibility. Maintain the ability to deploy capital opportunistically
The following are 3 examples of companies where Giroux's stress test rules apply.
BlackRock (BLK)
In my recent BlackRock post, I touch upon the means by which BLK has financed/is financing recent acquisitions.
On the Q4 2024 earnings call, management states:
For both the GIP and HPS transactions, BLK equity proved a valuable currency in consummating these transactions and structuring them for alignment with our shareholders.
BLK is issuing equity from a point of strength.
Paychex (PAYX)
On January 7, 2025, Paychex (PAYX) entered into a definitive agreement to acquire Paycor HCM, Inc. (PYCR) for ~$4.1B.
In concurrence with this announcement, PAYX entered into a commitment letter with JPMorgan Chase Bank, N.A. whereby JPM commits to provide PAYX with 100% of the loans under a 364-day unsecured bridge term loan facility in an amount not to exceed $3.50B. The facility will be reduced by an equivalent amount of the net cash proceeds of the issuance by PAYX of debt, equity or equity-linked securities in a public offering or private placement or the disposition of assets prior to the consummation of the transactions.
This is PAYX’s largest transaction. Were it to be permanently financed with 100% debt, its financial ratios would change dramatically from current levels. PAYX’s strong history of appropriate capital allocation suggests that the capital structure following the repayment of the bridge term loan facility will be very well aligned with the interests of long-term shareholders. It is also encouraging that Thomas Golisano (founder and Chairman of PAYX) and related parties have significant ownership in the company. Capital allocation decisions, therefore, have a significant impact on Golisano’s wealth.
BCE Inc. (BCE.to)
In my May 7, 2024 BCE Is A Dog With Fleas post, I disclose my decision to exit this holding despite having had BCE exposure since I was very young when my parents acquired shares for me. BCE’s financial predicament is such that a dividend cut is a very real possibility.
Important Considerations
Each firm has unique characteristics, and therefore, a Chief Financial Officer and the Board should stress test the firm’s capital structure to ensure the 5 stress test rules are never violated in the event of a downturn.
Too much or too little leverage can lead to suboptimal returns for shareholders. The key is in finding the right balance.
Companies operating in highly cyclical industries will undoubtedly need to approach their capital allocation strategy somewhat differently from companies in industries that experience little cyclicality. Giroux, however, recommends all firms consider the following important principles.
Minimize or reduce maintenance covenants in newly issued debt instruments and leveraged loans during periods of market strength when most market participants are less focused on a potential future economic or industry-specific downturn.
Maintain as large a line of credit/revolver capacity with your bank group as possible. This is a cheap insurance policy against a black swan event or a deep economic or industry-specific downturn.
Minimize the amount of debt that is in the form of commercial paper for all but the most resilient business models.
Have an optimal amount of debt in the capital structure that allows the firm to grow cash flows and earnings faster over time. The after-tax cost of debt capital in almost all cases is materially lower than the cost of equity capital. However, there is no need to push the envelope too far with regard to attaining the absolute lowest cost of debt possible. Issuing a lot of commercial paper and short-duration debt, having a few large debt instruments outstanding, and maintaining a small backup line of credit with your bank group will minimize your interest expenses and bank fees. However, it also increases the risk to the firm at exactly the wrong time in the business or industry cycle. In almost all cases, having a slightly higher all-in interest cost, especially on an after-tax basis, does not materially alter the earnings growth or cash flow growth rate of a firm with an optimal capital structure. In addition, it materially reduces the risk associated with that optimized capital structure.
The amount of debt in the capital structure should be directionally proportional to the volatility of the firm’s cash flows and more specifically, to the level of cash flows a firm produces in a downturn.
Final Thoughts
When I analyze a company, I look at the Debt section of the SEC filings for details about the terms of a company’s credit facilities. This includes but is not limited to the:
- interest rates;
- amounts of each facility, and
- maturity dates.
Although rating agencies don’t always ‘get it right’, I check to see what ratings are assigned to a company and whether the outlook is positive, stable, or negative.
Several of my holdings have no net debt or a low level of net debt (eg. Copart, Intuitive Surgical, Zoom Communications, CME, Veeva, Paycom, Chevron, and Exxon Mobil). Are their Balance Sheets too conservatively managed? Perhaps but they can weather a difficult business environment. Equally important, their conservatively managed Balance Sheets satisfy my reasonably low risk tolerance.
I highly encourage you to read David Giroux's book if you are a long-term shareholder. Should you be a very active trader who never reads SEC Filings, never bothers to understand what a company does, and you have no plans to change your short-term mindset…good luck. Don’t waste your time. This book is not for you.
I wish you much success on your journey to financial freedom!
Note: Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.
