Since the global financial crisis of 2009, total debt in the US has declined from a peak level of 350% of gross domestic product (GDP) to 311.5% in 2018. While the overall US debt picture has improved, the business sector has been accumulating mountains of debt, thanks to ultra-low interest rates. Corporate debt currently stands at a staggering US$9 trillion, higher than during the global financial crisis. What’s even more concerning is that the amount of US corporate debt sitting just above the ‘junk’ cut-off, has never been as high as it is today (Figure 1).
Figure 1: Market capitalisation of US corporate bonds by credit rating
Source: Gavekal Research data.
The ugly step-sister
The sharp fall in stock markets at the end of 2018 highlighted how vulnerable the financial system is to rising interest rates. The US economy had been racing red hot for over a decade, fuelled in part by ballooning corporate debt and share buy-backs. Signs of a potential downturn in 2018 due to the US Federal Reserve (the Fed) tightening monetary policy, saw debt to GDP ratios shoot even higher. What’s more, credit spreads (essentially the difference between what corporates and government must pay to borrow) blew out, making companies’ debt repayments much more expensive.
We don’t see the sheer volume of bad quality debt as a predictor of when the next recession will hit us. But we believe that when a downturn materialises, it will trigger a tidal wave of corporate rating downgrades from investment grade to ‘junk’ status. The search for yield has seen institutional investors hoovering up these corporate bonds. Large-scale debt downgrades would turn them into forced sellers, with the normally liquid debt market grinding to a halt. Liquidity pressures would spark widespread panic across debt-laden equity and bond markets. We witnessed the start of this unravelling last year, which threw economies and markets into disarray. Corporate debt became the ugly step-sister while defensive assets emerged as the Cinderella of the story.
But things are looking up, aren’t they?
Year to date, the macro outlook seems rosier. In January, the Fed signalled that the US central bank would put further interest rates rises on hold – a complete U-turn from its stance in 2018. What’s more, global growth is softening but still positive, inflation expectations have moderated, and credit spreads have fallen. We’ve seen a strong rebound in markets and risk assets, and the panic surrounding corporate indebtedness appears to have been swept under the rug. So, is it time to stop worrying about corporate debt?
The Fed’s softer monetary policy stance does not change our view on the potential weakness of global financial systems, markets and economies to leverage (high debt levels). Markets will continue to be tested when it looks as if corporate debt is likely to turn bad. There are two primary catalysts for this:
- Rising interest rates, which increase the interest bill that indebted companies must pay.
- Falling profits and margins, which also impact the ability of indebted companies to repay debts.
2018 was the year that investors worried about interest bills eating up corporate earnings and companies defaulting on their debt. These fears triggered spikes in volatility and sudden withdrawals of funds from weak markets, asset classes and companies.
Now that we can breathe a sigh of relief that the Fed is not rocking the boat, our attention should swiftly move to earnings.
Will corporate earnings be sufficient to pay these debt bills?
Tax cuts in the US buoyed earnings figures over 2018, but there is no longer such a tailwind going into 2019. This, together with slowing global growth, means earnings growth forecasts are being revised down for 2019 and 2020. Even if US rates remain flat, the cost of servicing debt is higher now than this time last year because of the rate hikes over 2018. If we see a profit squeeze, the most indebted businesses could yet again run into trouble, triggering the same wave of downgrades to ‘junk’ status, which in turn would spark a corporate debt sell-off. Weaker markets, asset classes and debt-laden companies will once again feel the heat.
Weathering market storms with financially strong companies
Difficult market conditions and the financial distress they cause are a reality that long-term investors face. The Investec Global Franchise Fund’s strong focus on quality companies with healthy balance sheets has helped our portfolio to remain resilient during challenging times. We seek companies that have the ability to generate strong cash flows and provide sustainable returns over the long term. They typically show low sensitivity to the market cycle, thanks to their enduring competitive advantages, sustainable profits and most importantly, low debt levels. These characteristics mean our quality companies are well placed to weather economic downturns and other financial market stresses.
Their financial strength acts as a buffer, providing operational flexibility in times of market stress. Lower debt levels mean our selected companies are not forced to refinance debt at unfavourable rates. Since inception, the portfolio constituents in our Investec Global Franchise portfolio have shown consistently lower net debt/EBITDA (net debt as a percentage of earnings before interest, tax, debt and amortisations) levels versus the market (MSCI All Country World Index). Currently, the portfolio’s net debt position is approximately zero (Figure 2).
Figure 2: Low leverage (net debt to EBITDA)
Source: Investec Asset Management and FactSet, as at 30.04.19. The above reflects the portfolio characteristics of the Investec Global Franchise strategy reweighted, excluding cash and cash equivalents.
Should the Fed change its stance and start a rate-hiking cycle again, the Investec Global Franchise Fund is well positioned to offer resilience. While the market (MSCI All Country World Index) lost 9.4% over 2018, the Investec Global Franchise Fund’s drawdown was limited to -4.5%. Hence, the fund outperformed the index by almost 5%, as shown in Figure 3.
Figure 3: Annual returns in US dollar – Investec Global Franchise Fund
Table 1: Annualised returns in US dollar as at the end of March 2019
|1 YEAR||3 YEARS P.A.||5 YEARS P.A.||10 YEARS P.A.||SINCE INCEPTION P.A.*|
|Investec Global Franchise A Acc||9.9%||9.3%||8.2%||13.0%||6.8%|
|MSCI AC World NR**||2.6%||10.7%||6.5%||11.8%||4.3%|
|GIFS Global Large-Cap Blend Equity||-0.7%||7.7%||3.7%||8.6%||2.0%|
Past performance should not be taken as a guide to the future, losses may be made. Data is not audited. Source: Morningstar, dates to 31.12.18 and 31.03.19, NAV based, inclusive of all annual management fees but excluding any initial charges, gross income reinvested, in US dollar. **The comparative index changed to the MSCI AC World Index from 1 October 2011. Highest and lowest returns achieved during a rolling 12-month period since inception: Feb-10: 54.4%, and Feb-09: -38.7% – Investec Global Franchise A Acc share class (*launch simulation date: 10.04.07). Quartile ranking within the GIFS Global Large-Cap Blend Equity.
Recognising that the interest bill is materially lower for our quality equity holdings than the overall market, we now turn our attention to profits and growth. We believe that enduring competitive advantages that create barriers to entry and pricing power, and strong free cash-flow generation are vital determinants of the sustainability of a company’s returns and growth prospects over the long term. Our quality businesses have delivered high quality profits over time. With healthy balance sheets and minimal capital requirements for growth, they can convert close to 100% of their profits into free cash flow. Through their disciplined and effective use of this cash, they have generated returns on invested capital (ROIC) well in excess of their cost of capital. Moreover, our companies’ average ROIC is almost double that of the average global company, highlighting their superior profitability profile (Figure 4).
Figure 4: Superior profitability (ROIC)
Source: Investec Asset Management and FactSet, as at 30.04.19. The above reflects the portfolio characteristics of the Investec Global Franchise strategy reweighted, excluding cash and cash equivalents. The comparative index changed to the MSCI AC World Index from 1 October 2011.The ROIC is different from the actual strategy performance and past performance is not a guide to the future.
In our view, very few companies exist that can consistently earn attractive returns, with lower than average volatility. This is only possible if a company has an excellent business model, a healthy balance sheet and sound capital allocation. The Investec Global Franchise Fund is therefore a high conviction portfolio of quality franchise companies that can collectively generate attractive growth in earnings and free cash flow, thanks to their financial strength and low capital intensity. What’s more, they are able to do this independently of external factors, such as interest rates and the economy.
Visa, the largest electronic payment processing network in the world, is an example of a financially strong company generating superior profits and growth. It is our top holding in the Investec Global Franchise Fund. Visa outperformed the market in 2018 by a staggering 25% in US dollars, reinforcing why we believe it is the highest quality company one can own. In what was a very tough market environment, Visa processed more than 124 billion transactions over the year, growing revenue by 12%, generating US$12 billion of free cash flow and returning US$9 billion of this to shareholders. How did the company achieve this?
Visa is what we call a robust compounder. It has a supreme balance sheet with virtually zero net debt. This financial flexibility, combined with its ability to consistently generate high quality earnings through the cycle, means that the company can drive robust profits and growth, regardless of the macro environment. And it is Visa’s enduring competitive advantages that give us a high degree of certainty that it can continue growing and compounding its earnings and returns going forward. Visa has one of the strongest and most trusted brands within the payments space, with close to 2.5 billion cards in circulation and 52 million merchant locations worldwide. Its advanced processing network is capable of securely handling more than 65 000 transaction messages a second. Visa’s business model is resilient – it earns a fee for every transaction that takes place on its network. While the fee appears insignificant to the card holder, it is substantial for Visa. Most importantly, its business model and attractive economics protect Visa’s margin.
With only 40% of transactions globally processed via credit cards, there is a long structural runway for growth as transactions move from cash to card. Given its sheer dominance in payments, technological innovations, global reach, trusted brand power, and limited operational and financial leverage, we believe this is a business that has the potential to grow earnings by approximately 15% over the next three years.
Do high corporate debt levels still pose a threat to the global economy and stock markets? Absolutely. The Fed’s about-turn on interest rates does not alter our view on the potential weakness of global financial systems, markets and economies due to re-leveraging. Markets will continue to be tested when there are signs that corporate debt is likely to further deteriorate. Although rising interest rates are not a risk for now, we believe investors need to keep a watchful eye on profits and margins.
Against a backdrop of rising corporate debt, we believe that our differentiated Investec Global Franchise Fund, which targets financially healthy companies that have the ability to provide sustainable profits, is well placed to weather economic downturns and other financial market stresses.