Most of us are aware of the tremendous amount of groupthink in the investment management industry, but what about corporate America? Little is written about the pressures placed on boards of directors and corporate executives to follow the herd. Wasn’t corporate groupthink at least partially responsible for the last financial crisis? Who can forget Charles Prince’s quote, “As long as the music is playing, you’ve got to get up and dance.” Few in the financial industry sat out the housing/mortgage bubble dance.
More recently we had a capital expenditure and credit boom in the energy industry. There weren’t many, if any, industry participants that didn’t extrapolate the boom and participate in groupthink. The industry was obsessed with production growth. Exploration and production companies were all doing the same thing – borrowing and drilling.
In my opinion, the most popular corporate strategy this cycle has been acquisitions, stock buybacks, and dividends. Although some companies have done this with free cash flow, many have funded at least a portion of these capital outlays with debt financing. Corporate debt growth is a theme I’ve discussed in previous posts. I’ve used several company specific examples to illustrate how balance sheets, on average, have weakened this cycle. The energy industry is again the most glaring example, but other industries have also piled on debt. Even high-quality companies have put on a lot of balance sheet weight, such as J.M. Smucker, which I discussed yesterday.
The Associated Press (AP) published a very good article a couple of weeks ago titled, “The Hidden Risk to the Economy in Corporate Balance Sheets”. While I’ve seen aggregate debt leverage ratios and charts supporting what I’m noticing from a bottom-up perspective, the AP article has some additional stats I thought were worth highlighting.
Given the amount of debt growth I’ve noticed over the past several years, I continue to find it surprising that some investors insist that balance sheets are in better shape this cycle. The AP article points out that this misunderstanding is most likely a result of a few mega cap companies that in fact do have strong balance sheets. However, when viewing balance sheets in aggregate, it’s a completely different picture. The AP says, “Of the $1.8 trillion in cash that’s sitting in U.S. corporate accounts, half of it belongs to just 25 of the 2,000 companies tracked by S&P Global Ratings. Outside of Apple, Google and the rest of the corporate 1 percent, cash has been falling over the last two years even as debt has been rising. It now covers only $15 of every $100 they owe, less than it did even during the financial crisis in 2008 when finances were crumbling [my bold].”
Another debt statistic in the article was particularly interesting to me as it is how I think about leverage. Many investors measure leverage in terms of debt to EBITDA. While I monitor debt to EBITDA, I like to measure leverage differently. Specifically, I want to know how long it would take for a company to pay off all of its debt. I like monitoring debt in this manner as I never want to be at the mercy of volatile credit markets or a fickle banker. I want to know, if necessary, if the company can pay off its debt before its maturity wall hits.
My rule of thumb is for non-cyclicals to be able to pay off their debt in five years and cyclical companies to be debt free in three years. I believe by following this simple rule, I’m in a better position to limit balance sheet driven losses. As an absolute return investor I never want a stock to resemble a goose egg. Absolute return investors must avoid large mistakes. As the GEICO commercial says, it’s what we do.
Do most companies pass my leverage thresholds? According to the AP article, the answer for most junk rated companies is no. “Companies whose debt is already deemed junk are in the worst shape in years. To pay back all they owe, they would have to set aside every dollar of their operating earnings over the next eight and a half years, more than twice as long as it would have taken during the 2008 crisis, according to Bank of America Merrill Lynch.”
Again from the AP article, another “not since the crisis” statistic, “The number of companies that have defaulted so far this year has already passed the total for all of last year, which itself had the most since the financial crisis. Even among companies considered high-quality, or investment grade, credit-rating agencies say a record number are so stretched financially that they’re one bad quarter or so from being downgraded to junk status.”
Finally, there is apparently an alternative to stocks (sorry TINA) – corporate bonds! The AP article states investors, “…put a net $22.8 billion into mutual funds specializing in corporate bonds in the 12 months through July, lifting total investments via such funds to $144 billion, according to Morningstar. The headlong rush reflects desperation for something a little more rewarding than the stingy interest paid by Treasurys and other traditionally safe bond offerings.”
With sales stagnant and earnings in decline, I don’t believe corporate organic growth is strong enough to rejuvenate the economy. Credit growth in one form or another will most likely be the drug of choice to get GDP growing again. With corporate debt at elevated levels by many measures, I don’t believe corporate balance sheets have sufficient capacity to provide the economic cycle with a second wind. While central bank balance sheets are unlimited, corporate balance sheets are not.
Yesterday I discussed J.M. Smucker and how their balance sheet’s leverage has increased. Given the stability of their business, I don’t believe J.M. Smucker is at risk of not making interest payments or becoming distressed. As long as they don’t do more acquisitions or aggressively buyback stock, I believe their bonds are sound (of course there’s still interest rate risk). However, considering the amount of debt they’ve taken on, I believe their flexibility in running the business has been reduced. Furthermore, increasing debt levels from here would move their debt above levels I’d consider comfortable, even for a stable business (it would exceed my 5x free cash flow/debt threshold). In effect, this cycle’s popular strategy of borrowing at 2%-4% to acquire, buyback stock, and pay dividends has its limit. In my opinion, many mature companies that have taken on debt this cycle are approaching it.
A large portion of the positive effects of piling on debt this cycle has already occurred. While credit remains very easy to obtain and is attractively priced, I expect corporate debt growth to moderate in the coming quarters. The decision to acquire competitors or buy back stock (especially near record prices) becomes much more difficult when leverage is already near 3-5x cash flow.
We may already be witnessing early signs of balance sheet exhaustion. For example, the pace of mergers and acquisitions during the first half of 2016 slowed. According to the StarTribune, “Nationally, there were 4,937 transactions during the first half valued at $757.3 billion, compared with 5,321 deals valued at $910.74 billion during the first six months of 2015, according to Dealogic, which tracks mergers and public stock offerings.” The article points to expensive valuations and the Presidential election as possible reasons.
Buybacks have also slowed this year. According to Reuters, TrimTabs recently reported, “The value of stock buyback announcements from U.S. companies slowed to its lowest level in four years.” The article also stated, “The number of companies announcing buybacks has also fallen, averaging 3.3 a day so far, the lowest since the third quarter of 2013 and well below the 6.1 per day during earnings season a year ago.”
Did corporations suddenly become price sensitive as it relates to acquisitions and buybacks? I don’t think so. Borrowing at abnormally low rates to acquire and buy back stock can still be accretive for most companies, as long as their balance sheets allow it. However, there becomes a point when boards of directors and corporate executives say, “Maybe it’s time we give the balance sheet a rest.” I think many companies I follow are reaching that level now. I don’t believe they’re necessarily distressed (outside of energy) or in a hurry to reduce debt, but are simply more reluctant about adding to existing debt. After a period of aggressive balance sheet expansion, it’s only natural to reconsider future leverage. A corporate balance sheet pause would explain a lot and shouldn’t be surprising at this stage of the credit and market cycle.