Which Way Now?
Comment of the Day

April 01 2020

Commentary by Eoin Treacy

Which Way Now?

Thanks to a subscriber for this report from Howard Marks which may be of interest. Here is a section:

Many companies went into this episode highly leveraged. Managements took advantage of the low interest rates and generous capital market to issue debt and some did stock buybacks, reducing their share count and increasing their earnings per shares (and perhaps executive compensation). The result of either or both is to increase the ratio of debt to equity. The more debt a company has relative to its equity, the higher the return on equity will be in good times…but also the lower the return on equity (or the larger the losses) in bad times, and the less likely it is to survive tough times. Corporate leverage complicates the issue of lost revenues and profits. Thus we expect to see rising defaults in the months ahead.

Likewise, in recent years, the generous capital market condition and the search for return in a low- interest-rate world caused the formation of leveraged investment entities. As with leveraged companies, debt increased their expected returns but also their vulnerability. Thus I believe we’re likely to see defaults on the part of leveraged entities, based on price markdowns, ratings downgrades and perhaps defaults on their portfolio assets: increased “haircuts” on the part of lenders (i.e. reduced amounts loaned against a dollar of collateral); and margin calls, in portfolio liquidations and forced selling.

In the Global Financial Crisis, leveraged investment vehicles like Collateralized Mortgage Obligations and Collateralized Debt Obligations melted down, bringing losses to the banks that held their junior debt and equity. The systemic importance of the banks necessitated their bailouts (the resentment of which contributed greatly to today’s populism). This time, leveraged securitizations are less pervasive in the financial system, and their risk capital wasn’t supplied by banks (thanks to the Volcker Rule), but mostly by non-bank lenders and funds. Thus I feel government bailouts are unlikely to be made available to them. (As an aside, it’s not that the people who structured their leveraged entities erred. The merely failed to include an episode like the current one among the scenarios they modelled. How could they? If every business decision had to made in contemplation of a pandemic, few deals would take place.

Eoin Treacy's view

Here is a link to the full memo. 

Corporate leverage has increased substantially over the last decade because low interest rates made balance sheet optimisation strategies a no brainer. What board would refuse the prospect of reducing the interest on existing debt by refinancing, and using the difference to reduce the share count? Afterall equity is an inherently more expensive form of financing. That was the logic in the early part of the cycle but refinancing was quickly exhausted. Companies then migrated to “maximising shareholder value” by inflating the share price with debt fuelled buybacks. Some companies are obviously much more guilty of this practice than others and have been among the biggest decliners so far.

I performed a Bloomberg search for companies in the FTSE 350 with a debt to equity ratio of more than 100% but which also have intangible asset values higher than their market caps. It seems reasonable that intangibles are the first thing to be cut from valuations in a contraction.

While a number of telecoms and utilities pop up in the list, they are likely to survive because of the necessary services they provide. The fates of companies like Cineworld, TUI AG, Firstgroup, National Express, Signature Aviation, Finablr, TI Fluid Systems, G4S and Marston’s are among the most likely to go into administration.

I performed the same search for the constituents of the S&P500. Those that immediately stick out for having a greater intangible value than their market cap are: Mylan, Discovery Inc, Coty, Nielsen, Capri Holdings, Hanesbrands as well as a number of the airlines and cruise lines.

The value of brands is something that can help a business to recovery once debt issues have been dealt with but they do not help with debt servicing in the short term. That suggests there will be ample scope for better capitalised companies like Berkshire Hathaway and/or private equity firms to feast on the overleveraged sector in the event of bankruptcies.

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