Stocks/International

Lyn Alden Schwartzer

Filtering Through the Noise to Find Value

The Corporate Debt Problem is Real

As interest rates have been low for a long time, corporate debt as a percentage of GDP in the United States has reached record heights: 

Chart Source: Gluskin Sheff

A lot of this money has gone towards share repurchases, which accelerates EPS growth and high stock valuations.

But as debt levels have climbed to high levels, companies have an eventual limit on how much debt they can take on, which may limit share repurchases going forward and negatively affect EPS growth and stock valuations. 

It’s a Bloomin’ Big Problem

My husband and I ate at Outback Steakhouse a couple weeks ago, and although I usually prefer cooking our own meals with our own ingredients, it was great.   

The place was packed, the waitress was friendly, and we both left satisfied. Naturally, I looked up the stock afterward to see how it’s doing these days.

Bloomin Brands (BLMN) has negative tangible book value, and net debt equal to about 10x annual net income. Rather than using free cash flow to aggressively pay that debt down to a safer level, they've been aggressively buying back shares over the past few years. 

But that's not too unusual recently, as the earlier chart from Gluskin Sheff shows. Corporations in a broad sense have taken advantage of low interest rates to boost their shareholder returns by shifting their capital structures from equity to debt. This is great in a bull market but makes them more fragile in an economic slowdown. 

It also means that the Federal Reserve is potentially handcuffed when determining interest rates going forward. During each economic cycle peak over the past several decades, interest rates have topped out at lower levels and debt levels have hit ever higher ratios.

2 Ways to Take Advantage of This

With corporate debt levels at record heights, and the Federal Reserve limited in its ability to raise rates without causing debt crises, there are a few simple things investors can do in my opinion to limit their exposure. 

1) Focus on Quality, and Diversify Your Risk Profile

The natural inclination of many investors is to buy defensive companies towards the later stages of an economic cycle. The idea with that approach is that you want to have more cyclical stocks with explosive upside potential during the early innings of an economic recovery, and to hold less volatile and more defensive names years later as the economy peaks and starts to turn down. 

Usually, defensive names refer to utilities, healthcare, and consumer staples. But is that an antiquated idea? 

Clorox (CLX) trades for about 26x earnings and has net debt equal to around 3x their annual net income, which is more manageable than Bloomin Brands. Coca Cola (KO) trades for almost 30x earnings and has net debt well over 4x their net income.

I'm not sure that's what I'd call defensive. Kraft Heinz (KHC) was considered defensive and look what happened there recently. They wrote down the value of their major brands by billions of dollars and slashed their dividend. When brand strength and intangible assets are the main thing holding a balance sheet together and represent the majority of a company's economic moat, it's important not to take that brand for granted and assume it can't weaken as consumer preferences change. Companies like Coke and Clorox might be no-brainer buys at cheap prices, but when they’re well north of 20x earnings it pays to be cautious.

The iShares Edge MSCI USA Quality Factor ETF (QUAL) provides some defense against ballooning corporate debt because it filters companies for low debt and stable earnings. However, investors pay a bit of a valuation premium for stocks in this club. 

The best of both worlds in my opinion is to buy cheap things that also have low debt. The catch is that you often have to put up with some volatility. 

For example, a lot of semiconductor companies have great balance sheets and are currently in a downturn. Micron (MU) has more cash than debt. Skyworks Solutions (SWKS) has zero debt. Texas Instruments (TXN) could pay off its entire debt with less than one year's worth of free cash flow if they wanted to.

Some out-of-favor tech giants like Alphabet (GOOGL) are under regulator scrutiny and thus relatively inexpensive compared to their peers. It trades for around the same valuation as Clorox and Coke but has stronger top line growth, $109 billion in cash, $59 billion in property, and a trivial $4 billion in debt. Its risk profile is very different than many other companies. 

The midstream industry is in a multi-year bear market, but there are some high quality names trading at low valuations now. Enbridge Inc (ENB) and Kinder Morgan (KMI) currently have much stronger balance sheets and distribution coverage than they've had in recent history. A lot of big money still seems to be avoiding the space due to ghosts of what happened a few years ago. I prefer focusing on ones with large natural gas exposure. 

Russia (RSX, RSXJ, ERUS) has some of the best debt metrics of any country, despite their other issues. Their household debt, corporate debt, and government debt as a percentage of GDP are all lower than the United States according to the Bank for International Settlements. They also have huge foreign-exchange reserves equal to 30% of their GDP to defend their currency if needed. Investors willing to put up with corruption and headline risk may benefit by putting a couple percentage points of a portfolio there while valuations are low.  

All of those sectors and places have risk. But the key thing is that it's not all the same kind of risk like many indebted companies in the S&P 500 have. It's a set of out-of-favor investments with very different risk profiles, low valuations, and low/manageable debt.

2) Buy Precious Metals as a Hedge

Gold prices (red line below) have consistently displayed an inverse correlation to real interest rates (blue line below, 10x for clarity): 

When interest rates in bank accounts or government bonds are significantly higher than inflation, investors have a strong incentive to put cash there and earn real returns. There's a big opportunity cost for holding gold in that kind of environment because it offers no yield.

However, when interest rates barely keep up with inflation or are even negative, big money often moves towards gold, which in that kind of environment has no opportunity cost for holding it and tends to retain its purchasing power over the long term. 

Government and corporate debt levels are very high. If the Fed were to raise real rates to any significant degree for the foreseeable future, interest payments on government debt would consume a larger share of the government budget and exacerbate the deficit, and many highly-leveraged companies would end up in junk bond status. Thus, I like holding a defensive part of my portfolio in an asset class that prefers lower rates or alternatively benefits from periods of economic stress. 

Disclosure: Long GOOGL, TXN, MU, ENB, KMI, RSX, RSXJ, precious metals

Lyn Alden Schwartzer covers North American stocks and international equity ETFs with a focus on fundamental valuation. Her background is a blend of engineering and finance, and she uses a dispassionate long-term quantitative and qualitative approach to filter through the noise and find value in stocks and markets around the world.
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