2019 is off to a good start due to several uncertainties being clarified in the eyes of many investors and the Market. In my view, some of these uncertainties have been delayed but are not fully resolved. 2018 was down because the fourth quarter experienced a Market downturn highlighted by a December that was the steepest decline for the Market since the Great Depression almost a century ago. Our investments faced headwinds in the fourth quarter because of the current U.S. administration’s trade dispute with China, the Federal Reserve’s interest rate increase with a credit tightening stance, and the wear off of the tax stimulus. 2019 has seen a rally due to several reasons explained below.
Inflation is showing signs of picking up in other categories. For years since the Great Recession, branded manufacturers faced triple headwinds for increasing prices from a price conscious consumer, generic alternatives, and young start up brands. Recently, the winds have shifted and manufacturers have been able to raise prices faster than the pace of inflation.
On a grander note on leverage, there have been large amounts of debt borrowed by companies and governments in recent years. Central banks in industrialized countries have issued unprecedented rounds of quantitative easing. The United States federal debt level and deficits continue to climb and the current pace of borrowing is not sustainable. At some point the amount of debt level, the debt maintenance expense, and cost of borrowing needed will be too much if the current pace keeps up. The 2018 tax cut accelerated the debt balance increase and deficits. However, the federal debt and deficit in the U.S. is currently manageable and it does not hamper my opinion of America’s economic prowess.
Large amounts of debt have been borrowed by private equity firms and corporations due to low interest rates. Private equity firms have driven up prices for their acquisitions and often times have overpaid for acquisitions because they are competing with each other with this “cheap money”, also known as low interest rate loans. Private equity firms buy out whole companies by loading them up with a lot of debt and then they will try to reduce operating costs, sell divisions, and other financial engineering before taking them public again or selling the company privately. These are leveraged buyouts, a term that has fallen out of favor from the 80s. In my view, private equity firms should really be called “private debt” companies because they are all about borrowing high amounts of debt while contributing as little equity as possible. This creates operating leverage, or also known as “juiced returns” which is a real risk to the companies they own. This has also contributed to higher asset prices.
Take an extreme example, if you borrow at a rate of 90% debt to 10% equity to purchase an asset and the value of that asset goes up 10% then you have doubled your money. The problem is if the value of your asset goes down 10% then your equity is wiped out. In other words leverage works both ways. Leverage can juice your returns but it can destroy your equity quickly. Too much leverage creates a situation where it can hurt cash flows because the company has to service the debt with principal and interest payments. Most importantly, debt will eventually come due and the borrower will have to pay it off or refinance.
Corporate debt usually has maturities of less than 10 years. Many companies who take out loans also have multiple loans, known as tranches. Multiple tranches often due at different years means these companies are in the Market frequently to refinance. Most of the time this is not a problem. However, if credit markets seize up as they occasionally do such as in 2008, then the company is in trouble.
Furthermore, too much leverage often leads these companies to skimp on investing in growth or reinvesting cash to maintain the business, also known as maintenance capital expenditures. Retail chains are especially susceptible to this phenomenon where store floors get dirtier, burned out light bulbs are not replaced, paint fades, employee morale decreases, and the overall look deteriorates. It forms a vicious negative reinforcement cycle. A few examples include Toys R Us, Sears, and Mervyn’s. Online competition and big box competition certainly hurt these examples but much of their demise stems from taking on too much debt. The same is true of venture capital, there is too much capital chasing the next home run start up.
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| Opportunities for long term investment trade between America and China will continue. |
America and China Trade Dispute:
The Chinese economy has been slowing for several years regardless of the recent trade dispute with the United States. China’s economy is undergoing a large scale transition to a services economy. It is also a matter of size. Now that China’s GDP is so large, it takes many more billions to grow the same percentage. The law of large numbers is at work here. A structural effect of using debt to fuel growth is that it is dependent on government liquidity injections every time China’s economy slows. The problem with relying on government stimulus is that it is similar to a drug addiction, it takes stronger doses to have the same effect with each subsequent use.
In China’s defense, other central banks around the world have used stimulus as well. Central bank stimulus spur more financing for projects. A systemic concern to China has been the one child policy creating a smaller next generation population. Although the policy has been loosened to two children per couple, there will be a bottleneck effect in the next several decades. However, that does not mean there is no opportunity. Quite the contrary, there are untapped pockets of opportunity. Plus a slowdown will most likely create investment opportunities for long term investors.
I am a big believer in the Chinese economy in the long run and the outstanding opportunities there. China has created a competing economic system of what I call State Sponsored Capitalism where many major industries are dominated by large corporations with the Chinese Government as the majority shareholder. Economic zones and 5 year plans where certain areas get extra funding and less regulation have created sprawling metropolises. For example, look at the modern city of Shenzhen. Just a few decades ago it was a fishing village. Now it is a hub of manufacturing, research, development, and technology with over 12 million people. That is larger than any U.S. city. However, there has been room for private companies to emerge as well. The Chinese Government can push head long into new sectors by sponsoring nascent companies.
