During the first weeks of World War I, many German commanders were reporting back to general headquarters about the successful attacks on French lines. Many boasted about encircling French forces and how they were retreating in disarray. Helmuth von Moltke (the Younger), who was chief of the German General Staff – on the receiving end of these reports – had severe doubts. He kept asking the same question: “But where are the prisoners?”
Moltke understood that claims of the French Army's collapse must coincide with the capturing of vast amounts of prisoners. Since there were very few troops captured, he realized the French Army was not routed, but instead carrying out a rather deliberate retreat, leaving the chance of a great counteroffensive possible. Moltke’s understanding came too late. In early September, the French and British launched a crushing counteroffensive that stopped the German advance cold and ushered in four years of grinding trench warfare.
I bring up this short history lesson after listening to Stanley Druckenmiller (Trades, Portfolio)’s interview that took place at the Economic Club of New York and a follow up interview on CNBC on June 7. In both events, Druckenmiller discussed how corporate debt has risen to $10 trillion in 2018 from $6 trillion in 2010 (a 65% increase). At the same time, corporate profits rose to $2.2 trillion from $1.7 trillion (a 29% increase). He pointed out that for a 65% increase in debt, total profits grew at a roughly 3% annual growth rate. To paraphrase Von Moltke: Where are all the profits?
It isn’t just the lack of profits Druckenmiller considers a problem. During the same period, companies spent $5.7 trillion in buybacks versus $2.2 trillion in capital expenditures. This is a complete reversal from the numbers in 2010. At that time, buybacks represented 20% and capex 65%. His concern is that companies haven’t invested in making their companies more productive or more competitive. Rather, cheap debt has allowed an enormous amount of companies that would – in more normal times – have faced bankruptcy put in place a systemic process to transfer wealth from the company to its largest shareholders and management. Again – to paraphrase von Moltke – where are all the bankruptcies?
A rather false narrative: the Russell 2000 and corporate debt
The narrative concerning the strength of the U.S. economy is based on two pillars – the strength of the U.S. equities markets and the burst in GDP growth after the tax cuts of 2017. While some may argue the markets have been rather flat for the past year (the S&P 500 is up roughly 3.8%), there is no doubt the tax cuts boosted GDP growth in the short term. But over time, the numbers tell a false narrative that puts value investors at grave risk. Let us take a look at a segment of the market and apply Druckenmiller’s concerns.
The Russell 2000 represents the smallest 2000 small-cap stocks of the Russell 3000. It is considered the best representation of U.S.-based small-cap businesses. As you look at the companies in the index, several statistics stand out and should cause serious reflection in all value investors[1].
- In 2018, 38% of the Russell 2000 had no net income, whereas only 1.4% of S&P 500 companies have no net income.
- 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 May 2019 that number sits at 34%.
- In the fourth-quarter of 2018 swoon, the Russell 2000 companies whose shares were in the highest quartile of percentage declines had a median debt-equity ratio of 41%. Russell 2000 companies whose shares were in the lowest quartile of percentage declines had a median debt-equity ratio of 32%.
- In the first-quarter of 2019 surge, the highest leveraged Russell 2000 companies gained 17% on average, while the least leveraged gained just 5%.
The graphic seen below (from Reuters) graphically tells the story.
This data can tell us some very interesting points about the investment markets.
Debt as a percentage of equity has never been higher
The amount of debt taken on by the Russell 2000 constituent companies has not been this high since the 2007 to 2008 market crash. Indeed, debt as a percentage of equity is far higher than prior to the crash. The vast majority of this debt consists of covenant-light (or "cov-lite) loans (as discussed in my recent article, Fata Morgana and the Illusion of Safety, which are very sensitive to interest rate volatility.
Debt as a form of capital has generated awful returns
The debt taken on by companies has provided little to no increase in productivity or profitability. Indeed, a quick review of 100 companies in the Russell 2000 by Nintai Investments shows that return on capital has decreased to an average of just 9.3% in 2018 from an average 14.1% in 2012. Additionally, companies with no net income has risen to 38% in 2018 from 26% in 2012.
Investors have lost sight of risk
The returns generated by the highest leveraged small-cap stocks in the first quarter of 2019 shows that investors have lost sight of risk associated with high levels of indebtedness. Combined with the fact that a large percentage of these companies have no net income, I would suggest value investors proceed with extreme caution in this market environment.
Conclusions
The last six to nine months have been a whipsaw for investors and business owners alike. The possibility of trade wars – being announced and rescinded by random tweets by the president – leave many of us without a clue as to where and what protections are afforded by business fundamentals[1]. Combined with the 180-degree change in the Fed's approach to raising rates (now even discussing lowering rates), the ability to look out and assess risk has become extremely difficult.
With all of this happening, it would seem that value investors must be extremely risk-averse when it comes to highly leveraged Russell 2000 (or for that matter any) companies. That doesn’t mean I haven’t been wrong before. Nintai Investments’ returns have beaten both the S&P 500 and Russell 2000 indices – barely – over the past two years as investors have clearly decided that risk is not a prime concern. My extreme aversion to debt and requirement of fortress-like balance sheets has afforded me little advantage against the general markets. Yet I would still advise value investors focus on one question – to paraphrase von Moltke: where is the risk? Once you’ve assessed and answered that question, then act accordingly.
As always, I look forward to your thoughts and comments.
Disclosure: Nintai Investments owns Skyworks Solutions in individual and organizational accounts I personally manage.
[1] I should point out I wrote about debt and the Russell 2000 in my article Leverage and the Stock Market in May 2018.
[2] As an aside, Skyworks Solutions (a holding in both personal and institutional investors’ accounts at Nintai Investments) is a supplier to Huawei (in January 2019 the U.S. Justice Department unsealed 23 counts including IP theft and obstruction) and has 39% of its assets in Mexico (President Trump threatened and then backed off imposing 5-25% tariffs on Mexican imports). It was a holding in our portfolio, but it is nearly impossible to generate a business case with any confidence going forward.
