The markets are nervous now. People’s anxiety about COVID-19 was immediately transposed to the financial markets sending even excellent companies, which сould hardly be affected by the pandemic, into the freefall. With markets becoming irrational, we stick to our Quality strategy and regard market sell-off as an opportunity to buy good companies at attractive prices. This month we, as usual, continue with insight on quality companies, focusing now on increasing corporate leverage, stating that high indebtedness is not a risk factor per se, but it could be the basis for further growth, given stable cash flows. And, by the way, the companies sitting in the lowest equity ratio quartile (excl. Financials) managed to outperform the market in the period from February 20 to March 9.
How to increase returns on capital?
ROE of 43% in 2012, 59% in 2015, 86%- in 2017, 143% in 2019 – looks like a stellar success story until it becomes evident that for the same time frame shareholders’ capital vs total assets decreased from 55% to 20%, giving a boost to the returns. High exposure to debt to keep up a high development pace and increase capital profitability is the way to go not only for MasterCard, whom figures above belong to. There are many companies, which finance their balance sheets primarily with debt, and investors tend to fall in love with them as long as they disclose promising development or improvement in the cash flows. Just look at the recent performance of Tesla or Netflix, whose risky balance sheets with an equity ratio of 18% and 21% respectively did not restrain investors from buying their shares after one has reported improvement in cash flows and increased vehicle production, while another surprised with strong growth in international streaming. Moreover, investors would be ready to provide them with additional capital to finance spending needs given their lower than average debt to market cap ratio.
There is a significant amount of cheap money on the market, which companies readily use to own advantage by increasing the amount of operating assets. The detailed analysis of total shareholder’s return of US companies, which is produced according to BCG methodology1, shows that historically there have been cycles of external financing extension and shortening. From a fundamental point of view, it seems that we are on the edge of the new leveraging cycle, which would support further corporate growth and, obviously, the increase in capital returns.
Growing debt does not always lead to SELL decision
Already now corporate debt in the US reaches a historical high of 10 trillion USD, which is 47% of the overall economy2. It means worsening the quality of balance sheets and leads to higher bankruptcy risks. Just in our February insight, focusing on Altman Z-score’s analytical value-added, we pointed out that for 62% of US companies bankruptcy probability has increased in the last 5 years.
The charts below illustrate balance sheets’ situation very well: 1) equity ratio has been in a long-term declining trend; 2) net debt is increasing vs EBITDA and equity. Noteworthy, a spike in net debt has been sharper if compared to equity rather than to the profit figures, hinting about companies’ ability to employ debt inefficient manner to generate higher earnings.
Fig. 1: Debt ratios, MSCI USA
We have also examined the relationship between debt and market capitalization, and there was no surprise for us to see that over time this ratio stayed virtually unchanged. This is an interesting trend, which indicates that investors don’t mind that companies are becoming risky on the balance sheet side. However, debt loading should be done in a wise way - like investing cash in R&D, marketing and other related expenses to generate further growth.
Fig. 2: Total debt to market cap, MSCI USA
Ironically, these investments often do not become part of the total assets in any form of intangibles (brand values, R&D in process, etc.), but rather are expensed. It leaves the company with lower retained earnings and, therefore, with lower equity capital and higher leverage.
Are quality companies in the trend?
Obviously, yes. Quality companies are also among the ones who exploit the leveraging trend to use cheap money in order to expand operations, innovate, enlarge addressable markets, make share buybacks etc. The amount of leverage for quality companies has been growing even faster than for the general market, and sooner or later these investments translate into higher capital returns – returns on equity capital have been increasing substantially, too (fig.3).
Fig. 3: ROE and Leverage, USA Quality vs. MSCI US
Mind the cash flows and KPIs
How not to burn the fingers when being invested in the highly leveraged company? The temptation to invest in such type of company is high, as at high stakes you usually get a high return. However, this mantra only applies to cases when the company is well-managed, has clear strategic and plausible investment focuses. These aspects require certain subjectivity in judgment, but the assessment can also be nicely done with the quantitative measures, such as key performance indicators and the measures provided by the big data. Latter could provide a good insight into the company’s development pace well before the corporation itself publishes the next quarterly results.
Additionally, one should mind the cash flow development of the company. Naturally, if a business is just burning the cash of bond- or stock-holders, reporting negative operating cash flows, it should be clearly a warning sign and a call to reconsider the investment.
1. BCG (2004). “Building an Integrated Strategy for Value Creation”.
2. Strauss, D. (2019). “Corporate America's debt load is nearing $10 trillion, a record 47% of the overall economy — and experts around the world are sounding the alarm” (link)