Who would complain being relieved of their debt burden? With inflation reaching a 40-year high in many regions, it seems that not only is the purchasing power of money eroding, but so is the burden of debt, measured in real terms. But is it really wise to buy stocks of companies with a lot of debt and hope they pay it off with cheaper money?
Chances are high you heard phrases like “during periods of high inflation, your debt will be inflated away!”
Some even suggest to take on debt to leverage their bets, because money loses its purchasing power anyhow. After some years with high inflation, the debt will be devalued the same way the money would have been, in case you kept it.
Hence, better buy a house or stocks leveraged with debt, let the debt become worthless and keep the appreciated asset, right?
As you know, I dislike the approach of building an investment thesis on the soil of hope. More often than not, this leads to disastrous outcomes.
With the unprecedented experiments of zero or negative interest rates coming to an end for good, a whole new investment environment emerges (respectively, comes back again). But the road will be very rocky, as many indebted people and entities will get into trouble, because they thought interest rates were abolished forever…
That way, is it really clever to have a high debt burden and hope for a final relief?
This blog being centered around investment ideas, we will first look in general at this questionable “strategy” and what the US government did in the past to inflate their debt away. I will explain what I personally look at before buying stocks of companies when assessing debt.
Finally, I will show you two businesses where every alarm bell should ring immediately.
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How governments “lowered” their debt
Many investors who are interested in history will either have read about or even experienced by themselves (the VERY experienced ones 😉 ) the period of post WWII until around 1980. It was not only a period of a restart having left the Great Depression of the 1930s and the following war behind.
Furthermore it was a time of economic expansion, a higher and rising standard of living for many and especially a period of deleveraging for governments. In this article I will focus on the US federal government, solely, to demonstrate my points.
The first chart starts from 1940 and shows the evolution of the federal debt in relation to the economy, measured by the gross domestic product:
Of course you will immediately see that currently the debt-to-GDP ratio is at a new all-time high, even surpassing the post-WWII debt load.
However, we want to focus on the period until 1980 in the first half of the chart. You see that this ratio came down after the war – measured by eye – by about 75% to find its bottom at around 30% around 1980.
How did this happen? Did the several administrations cut their budgets and repaid most of the debt? That is wishful thinking…
In the second chart, you see that government debt rose in nominal terms (i.e. as reported), continuously. There were some minor dips or sideways moves in between, but all in all, the trend is your friend in this case.
One option of course is to grow out of the debt load.
If the economy expands on a faster clip than government debt rises, this ratio comes down naturally. Although the total debt figure continues to rise, too, the relative debt burden becomes less, because the economy grows even faster.
This sounds like a good deal to the benefit of everyone.
Because both, debt and GDP, are static figures (or total amounts measured in static money-numbers), they grow naturally on their own, in case the value or purchasing power of the underlying – the currency – declines.
This is one way how assets (and debt) rise. The other two ways would be speculative demand that pushes prices up (tech stocks, anyone?) or shortages in supply (energy, food currently).
Unfortunately, the last paragraph is not understood my most people. Mainstream media and politics do their part. When prices rise (but also when something crashes), they always blame it on some sort of speculators who, however, are never found.
At least I have never read or heard about the guy that caused the 1929, 1987, 2000 or 2008–2009 crashes to be caught. Did you? Interestingly, when it comes to the 2020 crash – the fastest and one of the strongest – there was no “suspect”. Hmm…
Has anyone told you that inflation could be higher in Europe and Britain than in the US because their currencies fell against the USD? Both are regions dependent on energy and even to some extend food imports that are paid in USD, especially the former. This will not be the only explanation, but one part of it.
Hence, the third variable in this equation is the pace by which the purchasing power of the currency declines – this is what is commonly understood by “inflation” or the “inflation rate” and the pillar we are focusing on.
Let’s leave it here without diving too deeply and taking it as a given that there is inflation as a natural occurrence. Also, we don’t question at this point further the evaluated baskets of goods. Also, everyone has an individual inflation rate, because not everybody has the same income and the same expenditures. Just for simplicity.
The third chart shows the official inflation rates in the US:
This chart already starts somewhat earlier in 1914, but this shall not confuse us.
We see the highest inflation rate occurred in 1947 with around 20%:
20% is a horrible number for someone who just keeps cash. In just 3.6 years the purchasing power gets cut in half.
You can quickly calculate yourself the time it takes to halve by dividing the fixed number of 72 by the inflation rate. The result is the time it takes for inflation to eat halfway into your purchasing power.
72 / inflation rate = number of years for purchasing power to halve.
Side-note: The other way around, you can calculate how long it takes for your investments to double. 72 divided by let’s say a 12% return means that your investment will double in six years!
likewise, 72 / rate of return = number of years for your investment to double.
Looking at inflation numbers is one thing. But this should not be done on an isolated basis. If the economy grows faster than inflation, it has grown, indeed, in real terms. Most average investments should fare well in such an environment, too.
The goal should always be to generate returns in real terms!
The big but comes, however, in those cases where inflation surpasses growth rates (or investment returns). In this scenario, real growth or real returns suddenly become negative, because the purchasing power declines, although the growth rates might be positive by themselves – but expanded less than inflation.
If you earned a return of 5% (that would already be good this year) and the inflation rate is 10% or more, your real returns would be negative, nonetheless.
Little surprise, this is the environment we find ourselves in, now.
Whereas during most parts of the last decade you could earn 10% p.a. and nearly keep it, now you need to generate a return of double that number to experience a real return of the same magnitude. Always keep this in mind, it is about real – i.e. inflation adjusted – returns.
Because of that and the prior high valuations of most stocks, but also properties, with higher rates and thus higher requirements for returns, prices had to come down.
Those who thought or even worse said that inflation in general is good for stocks – sorry…
This means that most investors got poorer so far this year.
To show you the context, I plotted the two graphs of the the official inflation rate and the debt to GDP ratio into one chart:
We see both curves rotating around each other. It is not 100% consistent, but you should see a correlation between the falling debt to GDP ratio after the huge spike shortly before 1950 and the rising inflation rate, especially from the mid-1950s on until around 1980. Focus on the broader trend, not on every single yearly number.
While many people suffered and lost purchasing power (including those who invested in the wrong stocks), the big beneficiary was government whose debt load in real terms declined. Hence, this was the time of big deleveraging for government at the expense of the purchasing power of the currency.
This was also exactly the time of the “lost decade” with stagflation hitting in the 1970s with also high energy prices like we have today. The economy barely grew and even shrank in real terms due to high inflation.
What this means is, while the deleveraging was partly due to real economic growth and partly due to inflation in the first half of this time frame, the 1970s deleveraging was mainly inflation-based.
It seams like a deja-vu, doesn’t it? Nearly no growth and high inflation?
There is a very big, but crucial difference, however.
The main difference is that government back then already was deleveraged to a big extent. Today, government debt sits at all-time highs!
Don’t forget that, because it is important!
If you understood this, you will know why inflation is not feared that much by governments worldwide. They adjust their personal salaries and pensions accordingly. To the outside they tell you that they will do this and that and the evil companies will pay the price, because they act “unfairly”… The real issue, however, is not addressed – excessive government spending and debt… But that’s not for today.
But bad luck when the economy does not grow fast enough or at all…
Most of the time until the Great Recession of 2008–2009, it was always the strategy to shift from equities into government bonds until the dust settles. Then you could switch back again.
However, this doesn’t work anymore.
Why do you think government bonds have crashed parallel to equites and devastated all “safe” 60/40 or “all-weather portfolios”?
Just to remind you, the Dow Jones and the S&P500 had around 15 years of only going sideways in times of highest inflation, before they took off after the recession at the beginning of the 1980s:
Here is the S&P500:
During times of high inflation while wages and income are not able of keeping pace with increasing prices, most people are forced to count their budgets twice. This leads to greater reluctance in consumer spending, especially when it comes to discretionary items that are optional, but not necessary like food or energy.
Most companies (and their stocks) do not well in such an environment, because demand falls off a cliff. I explained this already in an article a few months ago (see here).
They are not able to rise prices enough to compensate for the lack of volume. At best, many companies are able to post nominal growth rates. But the growth is only due to price increases and most often lags inflation.
Thus, in real terms, there is no growth to be expected.
Central banks are doing what many thought would never happen again in their lifetimes. They not only started to raise interest rates again (even in Europe) which in itself caught many on the wrong foot. Also the pace of the hikes is record-breaking.
During the last weeks, markets hoped for a pivot of the FED, i.e. a slowdown in rate hikes. The FED indeed pivoted, but to the upside. The key message of yesterday’s conference (I listened to) was: “the terminal rate is higher than expected”.
So far, their rate hikes have done nothing to curb inflation. How should they when the problem is shortages (energy – watch diesel –, food, fertilizers, semiconductors, and so on)?
Here you see how the Fed’s Fund Rate has evolved historically:
The higher interest rates will cause many companies to have to stomach higher costs for servicing their debt. Some already have to pay now higher interest, if they use variable debt. Very dangerous… Some (former) home owners will know why…
Bad luck for those management teams that bet on zero interest rates forever.
On the other side, there are companies relying on debt to operate their businesses. We are going to discuss this in the next section.
What you should take home from this intro:
- if growth rates (GDP, investment returns) are higher than the inflation rate, the net return is positive
- if growth rates (GDP, investment returns) are lower than the inflation rate, the net return is negative
Real returns for many investors currently are negative, due to high inflation and most stocks underperforming.
Underperformance is one thing. But where you should really keep your eyes open, is whether companies have sound finances.
Now, let’s look at the corporate side.
Could companies deleverage during high inflation quickly, too?
A seemingly good idea could be to buy now stocks of the most indebted businesses in order to benefit from the expected devaluation of their debts.
Spoiler: This is a very dangerous thought and should be quickly pushed aside.
Obviously, not every business is the same. There are on the one hand capital intensive operations (mining, metals processing, telecom, airlines, cruise lines, properties businesses) and on the other hand so-called “asset-light” businesses (software being the most prominent, but also companies that have outsourced capital intensive manufacturing processes like some Pharma companies).
Many companies depend on taking on debt to finance their business necessities. Think of buying machines or properties.
Others just took on debt, because it was so cheap during the last decade. They used it for buying other companies or – I many cases – to buy back their own stock.
At the very minimum, you should understand the business insofar, as to being able to assess whether the company you are looking at really needs debt for its operations or not. Those that will need refinancing in the future and already have high debt, should be absolutely avoided. The situation cannot get better for them, but only worse with rising interest rates.
When pushed against the wall, they will cut the “juicy dividends” to pay down debt.
Businesses that have slim cost structures, good pricing power, high cash flows and maybe even some debt (they do not rely on down the road) are less likely to get into trouble.
What I like to look at to get a quick overview are the following points:
- pricing power and capital intensity of the business
(margins and CAPEX)
- interest payments
(the coverage in relation to EBIT and average interest rate)
- net debt, i.e. financial debt minus cash on hand
(in relation to free cash flows and its terms structure)
Let’s take the example of Apple (ISIN: US0378331005, Ticker: AAPL) to check its financial health. I use its recently released annual report that you can find here.
We all know that Apple is a cash generating beast of a business. Here is an overview over Apple’s profit and loss statement (P&L) from TIKR.com:
Apple generated 394 billion USD in revenues and has strong double digit margins.
From the cash flow statement below, we see that Apple generated 122 billion USD in operating cash flows during the last fiscal year. Only around 10% of the latter is reinvested into capital expenditure (CAPEX).
At this point, costs for sales as well as research and development are already subtracted from revenues.
The first question is answered. Though the numbers on a nominal basis and compared to other companies are high, the business itself and in relative terms is not capital intensive. Margins are strong.
What is left is around 110 billion USD in free cash flows. Cash flows that are for free disposition in the best interests of shareholders. Of these, AAPL used 14.8 billion USD to pay its dividend and 89.4 billion USD to repurchase its own stock.
From my second block we see that Apple paid 2.9 billion USD in interest rates on their debt outstanding. For many companies that would already be the death sentence. But Apple lives in its own world. For them, this is less than 3% of operating income or in other words: They have covered their interest expenses by more than 30x!
Nothing to worry on this front.
The average interest on its debt has to be calculated manually. Some companies present it to you, for others you have to do the work yourself. In the case of Apple this would not be necessary, but let’s do it once for a better understanding.
We need to divide total interest payments (i.e. 2.9 billion USD) by total financial debt outstanding (all numbers from the linked annual report, p. 31):
- short-term debt: 10 billion USD (“commercial paper”) + 11.1 billion USD (“term debt”) = 21.1 billion USD in total
- long-term debt: 98.9 billion USD (“term debt”)
- in total: 120 billion USD financial debt outstanding
The average interest rate is 2.4% (2.9 billion USD divided by 120 billion USD).
Nothing to be afraid of. Even if interest rates doubled for Apple, they would be able to comfortably repay it from their cash flows.
To make our overview complete, let us take a deeper look at net debt and the structure of the long-term debt. This is important to evaluate whether the debt is sustainable or if the company could be facing problems soon.
Apple has 23.6 billion USD in cash on its balance sheet plus investments of 24.6 billion USD (short-term marketable securities) as well as 120.8 billion USD in long-term investments (also “marketable securities”).
The bottom line is, Apple has around 165 billion in liquidity on its balance sheet. This is more than the 120 billion USD in financial debt. In other words, Apple has net cash of 45 billion USD. If they repaid all financial debt, 45 billion USD would be still available.
On the next two screenshots from the annual report we see that maturities last until 2062 (!) and that around half of the total financial debt is due only past 2027.
All in all, nothing to be afraid of. The individual yearly principal payments are low in comparison to what Apple generates in cash.
This was just to show you how I personally assess the financial stability of a company. In this case, of course, Apple has done very well.
In the last part of today’s Weekly, I show you two companies that could indeed face problems over the next years, due to very unfavorable debt structures on their balance sheets.
“Problems” does not automatically mean that the following companies will go bankrupt. I even think they won’t.
However, it is very likely that these stocks will be very poor investments with higher risks for permanent losses, even for those who “invest for the long-term”.
The main reasons I see are that in order to service their debt principals and in some cases even just their interest payments alone, measures taken will include capital raises (dilution of shareholders), suspension of buyback programs, dividend cuts or also refinancing at unattractive conditions – in case it will be available which during a credit crunch (last time 2020) will be very difficult.
Two companies facing debt problems soon
1. Easterly Government Properties (ISIN: US27616P1030, Ticker: DEA)
Formerly also known as the Easterly Group, this REIT (real estate investment trust) specialized on renting out its buildings solely to government entities. Their two biggest tenants are the Department of Veteran Affairs with 23.8% of rental income and the Federal Bureau of Investigation (FBI) with 16.5% of rental income.
Governmental tenants are said to be safe. I have no doubt – at least not in the near term – that there could be a default on rents due.
The stock price stands more or less where it started when the company went public, as you can see in the chart above.
But Easterly is highly leveraged and its debt structure is not long-term enough.
In their latest earnings results presentation (see here), they have many helpful charts so one does not have to do the work manually:
- the real estate business in itself is capital intensive
- Easterly uses a mix of debt and equity issues to finance their operations
- currently as of 30 September 2022, Easterly has 1.3 billion USD in debt and nearly no cash on its balance sheet
- EBITDA (used in the industry as a cash flow proxy) over the last twelve months was 167 million USD, i.e. debt to EBITDA is 7.8x which is very high
- however, I prefer to use operating cash flow, because from EBITDA you still have to subtract interest payments that especially in a capital intensive business should not fall under the carpet. Operating cash flow is lower at 118 million USD over the last twelve months. Debt to cash flows is a very high 11x!
- average interest rate is only around 3.5%, with 14% of debt having variable interest rates which rise together with the market. Refinancing will massively increase their interest payments down the road at the current Fed Funds Rate
- in order to pay down debt theoretically from equity issuances, Easterly would need to dilute shareholders by a whopping 73% (1.8 billion USD market cap only), however the debt is not immediately due and rents will rise over the years – just to be fair
What is already a good indicator that trouble will come soon, is the overview of the yearly maturities:
Next year should not be a problem, but from 2024 until 2028 every year more than 150 million USD in debt come due. This is in all cases more than the company is able to generate in operating cash flows currently.
In every single year, their capital expenditures have been higher than the entire operating cash flows. After that they also paid a dividend that cost every year at least half of the cash flow, sometimes even way more.
Though cash flows in absolute terms have been rising over the years, cash flow per share is nearly exactly the same it was in 2015. This shows you that as a shareholder you do not really benefit from any growth because the absolute growth gets diluted.
With the share price not far away from their all-time lows (!), it is really hard for me to see any positives. The dividend yield is 6.4%, but could quickly be cut when the company starts fighting for survival. Even the CFO was talking about “macroeconomic headwinds challenging the REIT industry”.
Better pass on this one.
2. Verizon Communications (ISIN: US92343V1044, Ticker: VZ)
Being one of the Big Three telecom companies in the USA, Verizon is a darling of dividend hunters. A current dividend yield of 7% is tempting, for sure.
However, I expect a crude awakening, soon, and see it more as a warning sign, not as a chance to make a bargain.
Year-to-date, the stock lost nearly 30% and is on a decade-low:
I don’t know how you feel after this short intro, but already at this point it does not look like a successful long-term investment.
Although the dividend has been raised yearly since 2007 (see here) and not cut even during the last down cycles, we should be approaching a point where management will have to make a tough decision.
The company has accumulated too much debt. Currently, Verizon has a market capitalization of 157 billion USD, a debt load of 148 billion USD and only 2 billion in cash on the balance sheet. In the short term – that is over the next twelve months – debt of the amount of a lofty 15 billion USD (or around 10% of total debt outstanding) is due for repayment or refinancing.
As I have shortly mentioned above, the telecom sector is one of the most capital intensive. The equipment has to either be constantly maintained, modernized or even expanded.
Although operating margins of around 20% seem nice at first glance, only half of that relative figure could be converted into free cash flow, recently. Before, the free cash flow margin only fluctuated around 15%.
This is due to high debt servicing costs.
Beides CAPEX, one should also subtract acquisition costs for wireless licenses from operating cash flows. These are recurring real cash outflows that are needed to operate the business.
With these figures, over the first nine months, Verizon generated free cash flow of slightly less than 10 billion USD. Of that, it currently pays 8 billion out in dividends.
It is relatively similar over the full last twelve months. Free cash flow was 14.3 billion, however before license expenditures of 3.4 billion USD and the dividend payment cost Verizon 10.7 billion USD.
More or less, a zero sum game.
This means, there is practically nothing left for debt repayment. Or in other words: refinancing at much higher costs (or way shorter duration) than in the recent past, will be necessary. Verizon already has bonds with longer durations that have coupons of nearly 9%!
The average cost of debt as of their last annual report has been 3.6%. This will be history and not repeatable again.
Interesting side-note: In the annual report 2021, the word “debt” is mentioned 178x! Plus, there are several warnings about the huge debt load. These warnings are obligatory, but one should also take them seriously!
Here is an overview of the repayment schedule over the next years:
You see that in every year until at least 2026, Verizon will have to refinance several billions, but there is not much free cash flow to factually repay some of it. Interest costs have been 3.4 billion USD over the last twelve months. This is also a decade-low. Expect to break first the 4 billion USD mark and later also the 5 billion USD. This will eat into free cash flow.
For me a clear sign that management underestimated their balance sheet strength. Maybe they thought interest rates would stay at zero forever, who knows…
More companies with a high likelihood of getting into debt problems, I have written in the past, are:
- MicroStrategy (ISIN: US5949724083, Ticker: MSTR): “Microstrategy stock: A superior way to invest in Bitcoins?”
- my top 10 companies due for a dividend cut, soon: “Bargain or pain? Ten dividend darlings that face painful cuts“
This new environment of rising interest rates will be no walk in the park. Especially for those that have never experienced interest rates and only joined the party over the last 2–3 years.
It will be a painful, but hopefully teaching experience.
Always be careful where you put your money into. I showed you, how you can do some simple checks which only take a few looks in the respective publicly available documents.
The result is clear: Avoid over-leveraged and highly indebted companies. The game of “inflating away the debt” will not work out in most cases, especially for those companies that operate in capital intensive businesses.
Also, better prepare for many dividend cuts or even suspensions. Debt repayment is senior to shareholder returns.
It is not a coincidence that besides absurdly overvalued tech-stocks among the biggest losers are companies with high debt loads.
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