In our last market update, we discussed corporate debt and company stock buybacks.  We see this topic as a bigger story than what has been reported so we thought we would again address the issue and give an example using a well- known company that has been doing this for the last few years.

A very smart corporate executive once said, “When the market allows you to borrow money, borrow as much as you can.”  Much of corporate America has taken this advice and has been doing exactly that over the past few years.  Why is this advice worth heeding?  Because at some point in the future it won’t be as easy to borrow money, as simple as that sounds.  The previous high water mark for corporate debt before the 2008 recession was $7.3 trillion.  Today, corporate debt is around $9.63 trillion.  What is disconcerting about all this debt is the manner in which it is being used.  Companies are not using their debt to expand their businesses through capital expenditures and grow organically, but are using the proceeds to buy back stock and/or make acquisitions as a means to increase revenue and earnings.  Below is a chart that shows the median percentage of debt used in recent merger and acquisition (“M&A”) activity in America.  M&A activity is being financed by debt at a clip of nearly 72%.  The previous high was 63% in 2007.  So, firms are leveraging up their balance sheets in order to leverage up their earnings.  Doing this increases risk.

Companies are also borrowing money to buy back shares.  IBM has been very active in this area over the past few years.  IBM has been a blue chip stock for as long as we can remember; however, IBM’s business model has been changing as mainframe computing is being replaced by the cloud.  Over the past nine quarters, IBM’s revenue has dropped progressively each  quarter, but earnings per share have risen.  How can this happen?  IBM has been on a borrowing spree and using those proceeds to buy back its shares.  According to this zerohedge.com article, IBM’s net debt has risen 55% over the past year with virtually all of that debt being used to buy back shares.  Because of this, IBM’s total debt to equity ratio is now over 250%.

What does this mean for Investors?

Raising money via debt issuance can be a good thing.  This is especially true when a business is growing.  However, when companies are borrowing just to borrow because interest rates are artificially low, it is a cautionary sign.  IBM is one of many companies taking on more debt to engineer higher earnings through share buy backs.  The Street has reacted positively to this tactic, but as interest rates normalize, this approach will become costly as companies will have to reissue more debt in the future at higher rates.  This dislocation of capital can only be fixed by the Federal Reserve taking the necessary steps to normalize their interest rate policy.  Until then, managing risk in your portfolios is still of utmost importance.

Book of the Month –  “The Billion Dollar Mistake – learning the art of investing through the missteps of legendary investors”, Stephen l. Weiss  

This is great book that consists of 11 separate stories detailing how top notch investors lost $1 billion on a specific investment.  It includes investors such as Kirk Kerkorian, Bill Ackman, Richard Pzena and Chris Davis.  Each chapter not only tells a story, but concludes with lessons learned that are helpful for even the novice investor.  The most interesting story tells how Volkswagen became the largest company in the world in two short days in 2008 and why one of Germany’s richest men, Adolf Merckle, jumped in front of a train to end his life.  It is a must read for any investor and shows that even the top investors make mistakes.  It is much cheaper to learn lessons from their stories than to experience them first hand.

Interesting fact – Three out of four teens lack the skill to understand a pay stub.

Sincerely,

Your THOR Team