There are two kinds of downgrade: There are those that occur because the company was an accident waiting to happen, and those that occur when good companies encounter bad luck. The second kind is difficult to avoid but happily is uncommon. The first kind is easier to avoid. Accidents waiting to happen typically include companies that don’t enjoy a genuine competitive advantage but behave as though they do. For example, commodity producer that has no control over the price received for its product, but makes large debt-funded investments to expand production capacity. A company with genuine competitive advantages will know what return it can expect from the investment, and can be confident that the returns will comfortably service the debt. However, companies that can’t reliably predict their investment returns can quickly find the debt burden becomes unsustainable. These types of downgrades can be avoided by ensuring you understand the sources and sustainability of the company’s competitive advantage. If that advantage is robust, management should be able to avoid the rocks. If competitive advantage isn’t strong, there may be trouble ahead.
Tim is the Portfolio Manager of The Montgomery Fund – a concentrated, All-cap Australian equity fund that aims to generate capital growth and income. Montgomery focuses on owning high quality businesses and generating superior returns.