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Thomas Macpherson
Thomas Macpherson
Articles (120)  | Author's Website |

Leverage and the Stock Market

Leverage and rising interest rates can make for significant capital losses over time

May 14, 2018 | About:

Nobody ever went bankrupt without any debt.” - Old New England Proverb

Rather go to bed without dinner than to rise in debt.” – Benjamin Franklin

As my readers know, I’m extremely conservative in my investment process when it comes to my investment holdings’ balance sheets and free cash flows. I prefer no debt and cash equal to 100% or more of total liabilities. I also prefer to not overpay for growth. This philosophy held me in good stead during the 2007 to 2009 bear market as more than a few highly leveraged companies imploded under enormous financial stress. Recently, I have been hearing a great deal about how we will never make this mistake again. Companies have cleaned up their balance sheets, whole industries no longer rely on the short-term commercial paper market and cheap debt is readily available when necessary. These things alone make me very nervous. I decided to test these claims by researching the smaller stocks in the publicly traded markets, utilizing the Russell 2000 as a proxy.

Before I get started, let me say my preference for pristine balance sheets and significant free cash flow has only hardened with time. In the portfolios I manage at Dorfman Value Investments, roughly 90% of my holdings have no short or long-term debt. About 75% have enough cash on the balance sheet to pay all current and long-term liabilities. On average, my portfolio companies convert 25 cents of every dollar in revenue into free cash. Financial strength matters a great deal to me.

The great (Un)learning of risk, debt and interest rates

The Russell 2000 Index is a small- and mid-cap stock market index containing the bottom 2,000 stocks in the Russell 3000 Index. It’s a great tool for looking at trends and valuations in the small-cap segment of the markets. In a recent interview, Francis Gannon, co-chief investment officer of Royce Funds spoke about leverage in the Russell 2000. He stated[1]:

The other thing is I think people are not focusing on the leverage in the Russell 2000. We've seen increased leverage from a financial standpoint within the Russell 2000. In fact, the debt-to-capital ratio at the end 2017 was actually higher than where it was at the end of 2007. People aren't focusing on financial leverage within many of these businesses right now.”

This statement focused my attention on debt load to a remarkable degree. What about the long-held beliefs about lessons learned and never making the leverage mistake again? The amount of leverage taken on by companies in the Russell 2000 has exploded over the past five years. In 2012 the Russell 2000’s total debt-to-capital was 19%. Prior to the Great Recession, the average total debt-to-capital was 29% at year-end of 2007. As of April 2018, that number sits at 36% -- considerably higher than right before the Great Recession.

I think this number should be a great concern to all small-cap investors. For me, this represents an enormous amount of risk silently ticking away on a company’s balance sheet. Reading through individual company financial statements, it is clear that a significant amount of this debt was used to repurchase company stock in the open markets. I have previously written that management has a tendency to buy back shares at exactly the wrong time as shares reach new highs. These purchases seem to fit the same pattern.

But it isn’t just debt in the Russell 2000 that should catch everyone’s attention. Coinciding with increased debt is the rapid increase in the LIBOR[2], or the London Interbank Offered Rate. In March 2017, the Libor rate was 1.82%. As of May 2018, this rate was 2.78%. Indeed, since its low in November 2013 of 0.58%, the Libor rate has increased to 2.78% in May 2018. This increase has raised interest payments by roughly $177 billion for companies in the Russell 2000 and decreased annual earnings growth by 0.35%. It is estimated that each additional quarter percent increase in the Libor rate will reduce earnings by 0.10%. Additionally, the 10-year U.S. Treasury has recently broken through 3%, putting pressure on consumer lending ranging from housing sales to auto loans.

Why this matters

Seemingly small changes in the Libor (or the future U.S. Secured Overnight Financing Rate) or U.S. Treasuries rates shouldn’t mask the risk to investors and their potential future returns. The subtlest changes can be magnified into truly breathtaking impacts in the markets. For instance, roughly one in three companies in the Russell 2000 produce no earnings. Of the remaining two-thirds of companies in the index, how many might join these failing companies after seeing increased debt servicing requirements?

Increased interest on debt means less capital for growth

I’ve often written about the importance of management’s skill in allocating capital. Taking on debt – in its own way – is a choice in allocating capital. All things being equal, debt would be no different than retained earnings when it comes to capital allocation. But the two are not the same. One comes with (remarkably small) interest paid on the balance sheet, while the other has a coupon attached to it demanding both principal and interest payments. The latter make it such that as interest rates rise there will be less capital to allocate later. Just ask Valeant how much capital is available to allocate towards growth in its business as of May 2018.

Interest on debt means less free cash

Not only do increased interest payments mean less money to allocate for growth, they also mean there is less free cash flow in general. During times of market uncertainty, one of the first real impacts is the rapid change in lending and credit standards. What seemed like an open spigot can go to a mere trickle on a day’s notice. What might have been purchased on short-term credit can suddenly be cash-on-demand. There is an adage that everyone should have six months to a year’s expenses set aside in cash for those tough times that hit us all occasionally. That line of thinking by corporate management is a wise approach to risk management.

Conclusions

Being a value investor makes me – in general a bottom-up investor. I like to purchase pieces of financially sound businesses at a significant discount to my estimated intrinsic value. But that doesn’t preclude me from taking a look at market trends from a higher level sometimes. The view from 30,000 feet gives me great pause at the moment. Historically highly levered businesses with rapidly increasing borrowing costs is a flammable combination. I think my policy of little to no debt with high free cash flow conversion is even more important today than it was a decade ago. As Franklin said, I’d be more than happy to go to bed hungry with a large stake in cash, than – upon waking to see my clients’ portfolios suffering from debt-driven capital losses.

As always, I look forward to your thoughts and comments.

Disclosure: None.


[1] “How Risky is the Russell 2000 Right Now”, Francis Gannon, The Royce Funds Small Talk Blog, December 8 2017.

[2] The London Interbank Offered Rate (LIBOR) is the benchmark rate that the largest banks charge each other for short term rates. Many debt instruments interest rates – such as corporate debt and credit cards – are partially or wholly derived from the LIBOR rate. After decades of manipulation, LIBOR is being replaced in the US by Secured Overnight Financing Rate (SOFR)

About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chief Investment Officer at the Hayashi Foundation, a Japanese-based charity serving special needs children and pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website


Rating: 5.0/5 (9 votes)

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Comments

snowballbuilder
Snowballbuilder - 4 months ago    Report SPAM

Hi Tom,

First is always a pleasure read your articles, how are you?

Second i deeply share your aversion for Debt.

Both personally (as of today i dont have any debt of any kind) and in my holdings.

The aversion for debt is something my grandfather has teached and passed to me by examples.

After reading your article i’ve rechecked my portfolio on this core topic

As of today i’ve 4 holdings

(They were 6 at 31/12/2017, then 1 has been taken over and i’ve sold the other 1)

Of these for:

ONE has 15 mln of net debt (at 31/12/17) with 42 mln of net profit and 50 mln of FCF (10% of FCF/Sales)

ONE has 149 mln of net cash (at 31/12/17) with 140 of net profit and 132 mln of FCF (21% FCF/Sales)

ONE has 381 mln of net debt (at 31/12/17) with 288 mln of net profit and 274 mln of FCF (22% FCF/Sales)

ONE (an investment holding) has 115 mln of net debt (at 31/12/17) with 72 mln of net profit and 647 mln of equity.

In my opinion all my 4 holdings fit the spot of low debt, well and conservative capitalized and high FCF generative companies.

This is an important element of what make me really confortable sitting on and enjoy the compounding.

Thanks for always share your thoughts and experience.

With friendship. Snow .

Thomas Macpherson
Thomas Macpherson premium member - 4 months ago

Hi Snow: Looks like a portfolio to be comfortable with no matter the markets! I think the model of low debt, high returns on equity/capital, high fcf/revenue, acquired at a discount to intrinsic will fare well over the long term . Why not let management do the heavy lifting and compound your capital? Thanks again for your comment. Best - Tom

snowballbuilder
Snowballbuilder - 4 months ago    Report SPAM

Looks like a portfolio to be comfortable with no matter the markets!

Tom thats another important element: being confortable with our porfolio and our holding both in good and in bad time. (When for long time is always sunny / many people tend to forget / that sometime will rain again)

As you say i’m fully confortable having only my 4 holding, i’ve buyed the first in 2009 (9 years sitting on) and the newest in 2015 (3 years sitting on) and that is working pretty well for me.

All that sayed i dont necessary suggest doing the same to anyone else. (To be precise i dont suggest anything to anyone :) ).

Anyone need an investment strategy and a portfolio that make sense to him and that fit well his personality, caracter, brain and stomach and that is coherent with his life and his family financial situation.

Just some thoughts. All the best. Snow

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