Many of the permabulls out there, when crafting their "ode to the US markets" usually chime out three points. I can quote them off the top of my head because I have heard them THAT much. They are...
- Spreads have never been so attractive.
- P/E's are at historic lows.
- Corporate balance sheets have never looked so good.
Their first argument is being debunked quite rapidly as bond yields rise. The second argument is just flat out false - only true if you use the 20 years of the greatest bull market in the history of all time as your "universe". It is also useless until you factor in earnings growth. Since, the two other legs of this now wobblier three-legged bull (metaphor alert!) have been sawed off, let me save it some time and finish the procedure and address the third - corporate balance sheets.
More specifically I will look at the the amount of corporate debt - because that's what these talking heads mean. The claim that balance sheets have never looked so clean is based on the fact that, well, they do. However, as investors in Bear Stearns's hedge funds found out recently, looks can be deceiving.
Let's see what these people are talking about. Below I have posted the debt/equity ratio for S&P 500 (equal weighted):
Based on the above chart, one would assume that these people are right - balance sheets look great. Unfortunately, how come there are also people on blabbing about global liquidity aka "leverage". Where is this so called leverage, and if its not on corporate balance sheet then how are they increasing earnings as much as they are?
The leverage is there, but is not easily identifiable on a balance sheet. It reveals itself instead in some of the entities who the corporations are indebted to from an earnings standpoint.
One way in which corporations have been able to produce outsize returns during a period of decreasing leverage is to shift the leverage elsewhere. The customer has been lucky enough to receive this gift. From a micro perspective, this comes in the form of account's receivables - an asset on the balance sheet. Companies extend more credit to their customers, shifting the liability on their balance sheet to an asset. This, is in turn a way to use leverage but just not their own. One accounts receivables measure that examines a company's extension of credit is accounts receivable turnover. I have shown this figure for the S&P 500 below:
A high receivables turnover indicates tight credit standards at a company. A low turnover indicates loose standards. As of the end of last year, we are at the loosest level in 10 years. So, instead of borrowing themselves, they choose to loan to costumers - shifting the burden of leverage. Where in the past, companies have issued debt to obtain capital hoping to generate a return on capital that is greater than cost - relying on customers to continue to buy their product or service. Now they provide credit in order to increase sales which become capital through retained earnings. This appears to be a much cheaper source of capital at first, but the costs may come in later. Eventually, they are increasingly leveraged to their customer ability to buy their product and pay its debts.
I have graphed what I contend is this shift below. It consists of the annual change in Receivables divided by Common Equity compared to increase in Long Term Debt divided by Common Equity. As you can see these two items used to move together, with an increase in receivables being mainly a function of operating activities. In 2005, this all changed and they began to leverage themselves less and customers more. This chart as well as the previous one, when examined together, tell this story.
This is all fine and dandy as long as their debtors are not over extended. But with corporate customers experiencing rising input and labor costs and consumers being squeezed by food, gas, and debt service expenses - this can not be assured. Below, I have posted a macro view of the picture. I have graphed per-capita consumer, non-financial corporate, and financial debt indexed to 2000.
As you can see, since 2000, while financial debt has soared, non-financial debt has increased less than inflation. Consumer debt has also risen a great deal.
Another place that leverage is hiding is through stock buy-backs. A company who has excess cash will use this cash to buy back shares. Since net income remains the same, but shares outstanding drops, EPS growth will increase along with buybacks. Most times it is done to prevent dilution of their earnings due to executive stock option exercises. This can be a self-feeding mechanism as executives whose compensation depends on stock price, will decide to do this, exercise options on the rise in the stock due to the earnings boost, therefore creating the need for further buybacks.
This practice makes most important financial measure look greater than they really are - usually resulting in their stock performing well. However, by using this cash to buy back stock and not invest in projects to grow, they are borrowing against future earnings not creating sources of new earnings. Since the number of shares outstanding has been falling as earnings have been rising, the denominator of the EPS number has been adding to the EPS growth. As the denominator shrinks but the underlying characteristics of the earnings stays the same, EPS is much more sensitive to a shift in a dollar of earnings then it was before the buy back. When earnings are increasing this is great, as they use this LEVERAGE to increase their share price. If earnings begin to decline or increase less than expected, this sensitivity should show up on the downside as well. Therefore as buybacks begin to slow, they will need to increase earnings by MORE than they were when they were buying back shares. This is similar to someone who makes many purchases on a credit card. Although, the amount of credit card debt per dollar of disposable income will fall as long as his income rises enough. If his income falls, or does not rise enough as he hoped it would, then his net worth falls due to the need to pay off debt.
Lastly, corporations have been hiding behind our geopolitical leverage. Domestically, they have been able to domicile some of their operations in offshore tax havens. This levers our government who now has to borrow more to cover taxes deficit it creates. They have also outsourced jobs, allowing for lower prices for the consumers, but leveraging this against the possibility that in the long run it will hold down domestic wages or cause unemployment resulting in poor economic conditions, and possibly higher taxes to cover welfare, unemployment, and entitlement programs. They also have allocated their pension assets to hedge funds and private equity funds in attempts to get better returns so that that their plan do not become more underfunded. These companies however use great leverage (as seen in the previously mentioned graph above for the financial sector). So, for a firm with an underfunded plan (liability on the balance sheet), they are essentially leveraging the asset component (plan assets) in order to decrease the liability (underfunded status). This has the effect of introducing leverage, but not reporting it.
All together, this paints a picture of a corporate balance sheet that has exposure to much more leverage than its 10-K would imply. What we need to realize is that public companies are constantly indebted to three main entities. They are indebted to their customers who drive earnings growth, the institutions who own a majority of its shares, and the economic condition of the country (or countries) in which they do business. All three of these entities have increased leverage in the last few years. Due to the fact that corporations are levered to these entities, this will not show up on the balance sheets, but should not be ignored. Time will tell what the actual market impact of this leverage will be. My bet is that our ignorance of this leverage almost guarantees us that this impact will not be a positive one. With the fact that the talking heads have been wrong on two of their three arguments above - something tells me that the third time will NOT be a charm
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