Till debt do us apart…

Let us drive away the evil effects of bad dreams, just as we pay off debts. –Rg Veda, 8.47.17

Ward off the she-wolf and the wolf; ward off the thief!  O night full of waves, be easy for us to cross over!  Darkness–palpable, black, and painted–has come upon me. O Dawn, banish it like a debt!  –Devi Mahaathmyam, hymn to Raatri (goddess of the night).

Artificial wealth comprises the things which of themselves serve no natural need, for example, money (or debt), which is a human contrivance.  –St. Thomas Aquinas

If you owe the bank a hundred dollars, the bank owns you.  If you owe the bank a hundred million dollars, you own the bank. –American saying

Do you own the government, or the government you?

As one looks out the window of the bullet-train that is the bond markets, one cannot help notice the busy stone buildings where the erudite central bankers of the world are engaged in an intensely competitive game of devaluing their own currencies.  In preview, yours truly thinks that developed market bond prices are wildly inflated and that we are living through one of the greatest bubbles in the Western world sovereign markets in recent memory, or indeed, ever.

A cursory look at global developed market sovereign bond yields is enough to convince even the most casual market participant that the said long bonds are perchance–just perchance–a tad over-valued.  As of last Friday, investors were willing to lend to the US government for 10 years at a 1.58% fixed rate of return, which is incidentally below reported inflation figures (as well as real inflation which is materially higher).  After accounting for inflation, this does not even constitute a return of capital, leave alone an adequate return on capital (Perhaps having the world’s most powerful navy has its advantages in the bond markets!).

Amazingly enough, this pales in comparison to Japan, whose yen-denominated long bonds have a current yield of 0.73%–I hasten to add that this is for 10 years.  It thoroughly befuddles me why investors seem happy to lend to the Japanese government at such paltry rates especially when you consider that the total tax receipts for Japan is now less than the projected total interest payments due.  Such are the vagaries of Mr. Market, the attention-deficient, hyper-active manic-depressive who is entertained daily on trading floors around the world.

One has to wonder, why, in a world of blatant financial repression and profligate currency debasement globally, investors still flock adoringly towards fixed income securities and that too, sovereign fixed income securities.  It is my opinion that global sovereign bond prices need to correct an eye-watering 35-50% for them to be trading around fair value (in other words, the returns to investing in sovereign Western long bonds are negative and core European, Japanese and US sovereign 10-year paper will start offering double digit yields).  That this spells big troubles is needless to say for global financial markets when this happens (we are well beyond the point of wondering if this will happen).  Whether the markets wake up to it in weeks, months or years is unknowable, and perhaps just as well–as it does keep things interesting.  Such an event would today be called a black swan, after Nassim Taleb’s book, but viewed through the clear prism of the nearly 5000 year history of the debt markets (and even the 100 year history of modern sovereign markets), this would is closer to a crow (and the cynic in me wants me to write that this is probably merely a fruit fly).

This is not all doom and gloom for, say, equity investors.  For instance, AB Inbev, the global brewer, raised 10 year paper at a mouth-watering 2%, funds yours truly is confident will be re-deployed into the business at returns well above that cost.  Over the last 5 years, AB Inbev generated an average after-tax cash return on total invested capital of well over 20%, aided in part by its relentless focus on costs and expanding profit margins.  Shareholders have cause for cheer, but such are the second-order effects of artificially low interest rates.  (As an aside, how exactly this creates employment in the US remains unclear, at least to this analyst.)  Lending to those who don’t need the money at all seems to be the credo of the yield-starved bond investor.

Monetary policy is excessively loose and obsessively focused on creating asset inflation at the expense of asset productivity.  For example, technology is a hugely deflationary force and a hugely beneficial force to civilization, yet monetary policy today doesn’t make allowance for this and considers deflation of any kind the plague itself.  Central bankers globally seem fixated on unproductive assets (like housing) at the expense of productive assets like businesses, technology and education.  In a yield starved world, credit has become extremely cheap to those who don’t need to borrow, and extremely expensive to those who borrowed freely in the past.  This was not exactly the intended consequence of super-accommodative monetary policy.  It is my humble contention that asset purchases, quantitative easing and the zero-bound interest rate are blatant acts of market manipulation and should be labelled as such and kept out of reach of small children.  By all recent accounts, the interest rate is a fundamental barometer of the economy and manipulation of the interest rate is a de-facto price control.  While there are some merits to temporary–repeat, temporary–slashing of interest rates like in the de-stabilizing markets of 2008/09, now with real inflation and cost of living tracking well above the target corridors of banks, rates should have been raised materially, and raised yesterday.  How keeping rates at zero today with inflation well into the high single-digits in industrialized economies is the correct monetary policy truly and utterly confounds me.  Is this really free market capitalism?

Let us now cast our eye to what the US central bank is doing, widely considered the paragon of effective monetary policy.  Its esteemed Chairman (and proponent of counter-cyclical monetary policies relying almost exclusively on the depression-era economics of the late 1920s and early 1930s in the US), is hell bent on keeping rates at 0 in the hope that it increases home and stock prices (it is the stated rationale that this spurs consumption and creates employment–a sentiment which is as misplaced as it is amusing).  In theory, low interest rates should result in higher capital expenditures by businesses who see projects formerly that were NPV negative but which are now NPV positive and hence worthy of investment.  However, my feelings here are similar to Yogi Berra’s: that in theory, there is no difference between theory and practice, but in practice, there is.

How so?  Well, this assumes that corporations and investors mechanically use the long-bond yields as the risk free rate and apply a risk premium spread over this to anchor their yield expectations.  My contention is that this is generally true when interest rates are normal, but rational investments in physical projects and long-term capital commitments should be based on an absolute rate of return and not some make-believe risk premium added to a make-believe risk-free interest rate (perhaps today’s developed market bonds actually offer return-free risk?).  Only in finance textbooks are investors able to eat risk premiums for breakfast.  In the real world, what puts bread on the table is absolute cash returns on committed capital.

I am certainly not suggesting that monetary policy has no effect whatsoever on investment activity (and hence employment)–it certainly does.  But the question I would like to raise is whether the central banks are honest about what they are trying to accomplish.  Is inflation really running in the low-single-digits?  If yes, I would like to know how central bankers live and shop and travel: actual cost of living indices point to a materially higher run rate of inflation and if this does not prompt tightening, then what will?  And if we are being told monetary policy will be loose for the next several years, what does that tell us about how honest central bank monetary policies are?

It is my opinion that this is only a facade and that the real intention for such policies lie elsewhere.  If I were the US central bank, I would be praying desperately on my knees for high inflation (which reduces the real debt outstanding), such inflation to go unnoticed (by manipulating the published consumer price indices through “sophisticated” adjustments that defy common sense but requires advanced math degrees to “truly understand”) and in the meantime, keep interest costs as low as possible (to keep servicing costs of current debt as low as possible).  That the populace doesn’t see through this is the real reason such policies are allowed to be even legal.  The corridors of governments today are teeming with neo-Keynesians, who wouldn’t recognize Keynes even if he stood right across them and slapped them in the face.  As a wise man once said, in a democracy, people get the government you deserve.

Inflation, deflation and reflation

Such a dangerous policy, which is at best experimental speculation, flies in the face of common sense.  Too much debt is the problem which got us here in the first place, not the solution.  And it is clear as day that current easy money policies globally are looting the rational, clear-thinking savers to subsidize the profligate, spendthrift borrowers who over-extended themselves by borrowing money they couldn’t afford to service to buy things they didn’t really need.  This strikes me as encouraging exactly the wrong kind of behaviour in a rational, civilized society.  The Austrian school economists will tell you that this is de-facto inflationary and they have good reason and ample empirical evidence to support their claim.  Just to make a point but stopping well short of predicting this will happen, consider this: what stops debt-laden governments from writing off mortgage debts in an act of racy reflation?  What seemed far-fetched a few years ago doesn’t seem so crazy anymore (hey, what’s a coupl’a trillion between friends, eh?).

On the other hand, deflation remains a real threat too.  With asset prices artificially supported and money velocity dropping in some markets, a rational case can be made for deflation as easily as it can be made for inflation.

Consider this: since the last economic cycle peak in the year of our lord 2007, well over half of global money supply growth has come from emerging markets where central banks routinely intervene to contain their exchange rates (and inflation).  But if emerging market trade balances and external accounts deteriorate, this era is could be over.  Any slowing down of these economies has the dual impact of producing lower commodity prices (clearly deflationary) as well as potentially leading to money supply contraction.  Stunningly, US money supply growth has not even accounted for one-fifth of the global money supply growth over the last five years (including the nuclear policies of the US government).  China, Brazil and India have contributed more than twice the USA–granted, the former group has grown faster than the US, but it has also been driven in no small part by cyclical industries as well as exports relative to internal consumption.

Straddling two worlds…

To make a verbose paragraph pithy, the bottom-line is this: outcomes from here are skewed heavily towards the so-called fat tails of the probability distribution–on the one end is high inflation and on the other, much like yin to yang, rests deflation.

So what is an investor to do?  First and foremost should come the very humble recognition that the outcomes over the next 5 to 10 years are simply unknowable.  The forces of inflation (aggressive money printing and run-away expansion of central bank balance sheets) and the forces of deflation are each extremely powerful and today the tight-rope between them is disappearing shockingly quickly.  These hugely destabilizing forces will someday have to move to an equilibrium point with vastly different outcomes.  Hyper-inflationary conditions cannot be ruled out.  So can’t depression-like outcomes.  In an inflationary (or hype-rinflationary) economy, real assets like land, gold or farmland would be the beneficiaries.  But in a deflationary spiral, cash is king.

The conceptual framework for asset allocation today could probably best be described as a straddle on a global inflation index based on your own personal basket of consumption (it has never proven wise to rely on government statistics on inflation as every government in all of history has either explicitly or implicitly tried to manipulate inflation indices to portray a benign level of inflation).  It is irrelevant to you what the UK CPI reads or what the Indian WPI reads, what is relevant is how your personal cost of living has moved: look at your grocery bill, rents or travel expenditures and compare them to the published inflation figures.  Are they really a faithful representation of inflation?

How might you compose this straddle?  I hasten to add that taking a speculative bet on either inflation or deflation has materially higher payoffs but is a far riskier strategy if you prove to be wrong (and my central premise is that nobody–nobody–knows what the effects of such policies are).  If you accept that this is unknowable, the only risk-averse way of preserving capital would be to judge your portfolio against its ability to weather all outcomes.

It is my submission that there are three types of assets which you can own to have reasonable risk-adjusted returns.  As always, the following should not be construed as financial advice and you should always consider your own personal needs and circumstances before any financial decisions.

The first is Graham/Schloss type equities which are either available at a huge discount to intrinsic value or are market-independent special situations.  By owning these, you are betting that such securities do well no matter what the market environment is (i.e., you are buying alpha and not beta).

The second is an inflation linked basket.  This would be physical gold, productive farmland or other real assets which have proven to hold their real value over long stretches of time.  This analyst favours gold due to its liquidity, age-old acceptability as an alternative currency anywhere in the world as well as a long-term track record of holding value against inflation under loose monetary policy environments.  Another inflation hedge is your own competitive ability in your chosen field of work–if you invest in yourself and get better at what you do every day, you are guaranteed to keep your share of global GDP whatever the environment.  The best surgeons in the world will do just fine and so will the best engineers and lawyers.  Equities generally will not do well in highly inflationary environments especially if accompanied by high bond yields as the P/E multiples (or earnings yields) of stocks compete with other lower risk assets for marginal investor dollars leading to a de-rating of the equity asset class as a whole.

The third is the deflation basket, which is essentially cash.  Nothing else will outlast a massively deflationary shock.  More importantly, cash has option value (you can use cash to buy everything else) which should not be underestimated in a world where bimodal outcomes are expected.

And as a bonus, a fourth basket can be construed as well and this is the basket of high quality businesses which are debt-free, generate loads of cash (which can be paid out as dividends or can be reinvested into the business at healthy rates) and have the operational flexibility and managerial integrity to steward shareholder capital in both inflationary and deflationary conditions.  Such businesses are few and far between, but they will corner the lion’s share of the supernormal profit pool over the next 10 years–and you will likely sleep a lot better knowing you are a part owner in a productive high quality asset.

Having said all this, it is worthwhile (if only for the sake of intellectual curiosity) to wonder why it is that markets behave the way they do and why such outcomes are not priced in well in advance (as they teach you in text books)?  Greece was a basket case well before bond yields spiked but for some strange reason, investors simply didn’t notice (or chose to ignore it) till it became inevitable.  Markets are discounting mechanisms, or so we are told, and you can trade one dollar today for a dollar in the future and participants try to price in the future today.  Unfortunately, markets are human constructs and are hence driven as much by human traits like greed, fear, envy and over-reaction as by financial traits like yield, safety, returns and risk.  This has been true of tulips in Netherlands, railroads in the 19th century in the US, the technology bubble of the late 1990s and for sovereign bond yields in Japan today.  As always, seeking a margin of safety and sticking to what is knowable results in a higher probability of capital preservation (and dare we dream, appreciation).

–RN

(with editorial inputs from RP)

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Debt and equity

First some entertainment – eerie dubstep via Kottke and brother-in-law.

Instead of telling you what this new address in the electronic world is about, let me get down to writing a post and hope you figure it out. I had a recent conversation about this interesting item from Bloomberg with an analyst:Janus best as bond acumen boosts stocks. We had a follow up conversation which I thought worthy to summarize in this first post.

The Bloomberg link talks about a fund that used credit analysis to identify stock opportunities – does it make sense, and can it be applied? Basically good balance sheets (I mean low debt) increase survivability and contribute to longer term equity returns (while the article pointed to a couple of special situations, we discuss broad topics here). Generally you find sectors that earn low return on capital lever up their balance sheets to earn decent ROEs for the shareholders – typically these are competitive sectors where product differentiation may be hard to achieve, or pricing power for one or another reason is lower.

This is what GMO’s recent whitepaper in June alluded to: “Empirically, companies with persistently high profitability have lower leverage, and companies with persistently low profitability have higher leverage“. If it still is not convincing, think about sectors that are heavily levered – cement (essentially a commodity that faces intense local competition), infrastructure (market bidding for projects takes away value at inception, even in BOT projects) and utilities (regulated utilities try to increase ROEs via leverage because pricing power is capped). On the flipside, a downturn hits these companies hard – on one hand demand suffers, and on the other leverage hurts.

As a credit analyst you are worried about what would happen to leverage and coverage ratios going forward, and will companies be able to refinance debt at reasonable cost when it comes due (or otherwise have funds to pay it back fully) – which brings me to an often underappreciated point in the equity analyst world – how will capital expenditure (“capex”) be funded? For an underlevered company, if it can be funded fully out of internal accruals, then 2 years from now, balance sheet is going to look clean, and Free Cash Flow (FCF) from the additional capital employed will belong fully to shareholders. This is what is refered to as compounding – you can keep reinvesting capital generated back into the business and earn higher and higher capital – give it a few years or a decade or two and a snowball becomes an avalanche. In the above scenario, you expect both credit and equity to benefit. Think of Page Industries or Castrol Limited over the last decade, and Indraprastha Gas over 2007-2011. Is Kaveri Seeds on this path?

Then there is also organic deleverage which presents attractive opportunities for both credit and equity – ROCE (return on capital employed) is so high that debt is no longer needed for capex or for other reasons and credit ratios improve. And equity benefits from reducing WACC. Stock and bonds both give above normal returns in this scenario. Think Bajaj Electricals in mid noughties and the impact a good business and a delevering balance sheet had on the stock.

You can think about scenarios where one of the two (credit versus equity) benefit while the other is worse off- a) Creditworthiness suffers when companies chase growth and screw up their balance sheets by raising lots of debt while having a rosy expectation of the future. Equity may or may not benefit depending on whether incremental roe is higher than marginal levered cost of equity ( you need to think beyond a year, when all those new debt funded assets come on-stream, what would be the realized return?). Think levered cement and infrastructure companies in India.

b) Equity gets hit over the short run when there is dilution to repay debt (usually the route in the case of debt restructuring when existing debt holders get paid partially in stock), but will increase survivability over the long run and reduces WACC (so partially positive for equity too though the short term is painful). This is positive for credit as outstanding debt reduces and improves leverage ratios. Keep in mind however that the ultimate prospects of equity returns even in a restructuring scenario will depend on whether business profitability improves after restructuring i.e whether it can generate enough cash for capex and repaying debt, as well as whether entry price for the stock is attractive enough. Think Wockhardt Limited in 2012. Can Subex improve profitability going forward?

So finally it boils down to this: Debt is a strong statement about the future. Be cautious about taking on more than you can chew. From an equity investors’ point of view, avoid leveraged companies because overlevered companies tend to be in bad businesses to begin with. If you can find a business that can fund its growth without borrowing and has demonstrated competitive advantages (therefore high ROIC) with management that is conservative about cash and debt, and even better hold stock themselves, then you probably have a winner in your hands. If you can get your hands on such a company at an optically fair valuation where a median company trades, it would likely still prove worth your money. From a practical standpoint, in countries where interest rates are high, like India, a debt/EBITDA of 1.5 and an EBITDA interest coverage of 5 are thumbrules to look for. Breach of either of these probably means you are in a slippery danger zone – a small downturn or increase in capex would hurt cash flow and balance sheet tremendously. Avoid such companies where you can, or if you love the business, be sure to buy it cheap.

So if you have made it thus far, welcome to our world. This blog is written by two analysts and, if all goes fine, will cover investment ideas across the spectrum, but with a special focus on stocks. We may mention plenty of companies, and it is safe to assume we have a position in companies we discuss and we may also make mistakes. All investment ideas discussed or mentioned in passing are not recommendations but the nature of freewheeling thoughts. Please consult a financial advisor before acting on ideas obtained from our discussions. We do not take responsibility for your investment decisions.

-RP