Every financial crisis in history has been caused by leverage (borrowed money) and moral hazard.
An asset goes up in value. People chase its value higher. People start using borrowed money to invest in the asset, and as a result, they make a lot more money, faster.
They borrow more. The lenders are happy to lend the money, because their customers’ balance sheets look healthy, and besides, they haven’t defaulted in the past – why would they start now?
The system works. Lenders lend money, prices go up, they get their money back, everyone gets rich. And because the system works, people push it to extremes.
Eventually everyone owes everybody else. It only takes one tiny thing to go wrong before the whole network of transactions unravels.
And that’s when things get nasty…
Why you need to think about debt when valuing companies
The price/earnings (p/e) ratio is a popular valuation measure. It takes a company’s share price, divides it by earnings per share, and thus gives you an idea of how much the market is willing to pay for any given £1 of earnings.
If the p/e is high, then investors are willing to pay a lot for £1 of earnings – perhaps because they expect rapid earnings growth, or because it’s the best option available compared to likely returns elsewhere. If the p/e is low, then the market is not willing to pay much for £1 of earnings – perhaps because it fears they are about to dry up altogether.
The p/e is a useful rough and ready tool. And the Shiller p/e (or Cape) is a useful upgraded version of the p/e – it uses ten-year average earnings, rather than a single year’s earnings.
However, there’s a small problem with the “p” side of the equation. A typical company is not just funded by equity. It’s also funded by debt. And the more debt a company has, the riskier things are for the equity owners – because creditors get paid first. If there’s nothing left over for the equity owners at that point, then tough luck.
So some investors prefer to use enterprise value (EV). Enterprise value takes account of a company’s debt, as well as its market capitalisation. You divide EV by another measure of earnings – EBITDA (earnings before interest, tax, depreciation and amortisation) – and it gives you an alternative to the p/e ratio that takes into account debt as well as equity.
Why am I bringing this up now?
Well, I was just reading an interesting piece from James Montier, the well-known behavioural economics expert who now works for US asset manager GMO.
Montier is bearish. He reckons that the US stockmarket is heavily overvalued, and he doesn’t agree with his colleagues at GMO that we can’t really be in a bubble because there’s no real evidence – on the sentiment side – of irrational exuberance.
We keep hearing that on the Shiller p/e measure, stocks are at their most expensive apart from in 1929 and 1999. The 1929 record is one that we’re very close to, but the 1999 peak is still well above where we are now. That gives some succour to the bulls who argue that not only is the Cape over-exaggerating how overvalued markets are today, it’s also been much higher in the recent past (if only on one occasion).
However, if you take a look at the market’s EV/Ebitda multiple (which Montier does by knocking a few different measure together), then, as he puts it, the market “is fast approaching the obscene levels of expense that we witnessed in the madness of the TMT [technology, media and telecoms] bubble”.
The incredible shrinking US stockmarket
This strikes me as particularly interesting given another piece of research that I read over the weekend.
Credit Suisse’s Michael Mauboussin – another behavioural investment expert – put out a piece noting that the number of companies listed publicly in the US has fallen precipitously in the last 20 years or so. In fact, the number of companies listed in the US has halved since 1996.
In 1996, there were 7,322 listed companies in the US. In 2016, there were just 3,671. And to put that into some perspective, in 1976, there were 4,796.
There are lots of reasons for the decline in listed companies, reckons Mauboussin. Merger and acquisition activity is a big one (obviously, a company disappears from the market when it’s swallowed up by another one) while the number of IPOs (companies listing on the stockmarket for the first time) has collapsed. This is also primarily a US phenomenon. (It’s something I’ll look at in more detail in this week’s magazine – subscribe now if you haven’t already done so).
But on top of the fall in the number of companies being listed, companies are increasingly funded with debt rather than equity.
Listed company managements have always had good reason to indulge in financial engineering. If you want to make your bonus, you have targets to meet. For managements, these targets are often related to earnings per share.
To boost earnings per share, you can do one of two things. The first option is to drive up earnings. You can do that in many ways, some of them genuinely beneficial to shareholders (improving efficiency and thus profitability), and some of them not so beneficial (buying a big expensive bolt-on acquisition that gives the illusion of growth today, at the expense of big write downs in the future).
But there’s something else you can do: don’t worry about earnings at all, just reduce the number of shares in issue. Then simple arithmetic will drive up earnings per share for you. And if you don’t have the free cash flow to spend on share buybacks, then you just borrow the money.
When interest rates are low – as they are now – borrowing money is easy and even seems to make sense. So that’s what companies have done: “chosen to issue debt and repurchase equities on a truly massive scale”.
That’s a problem, because, as Montier highlights, it makes the whole system more fragile and vulnerable to shocks. “Low rates allow debt issuance, and equity repurchases line the pockets of corporate managements and (participating) shareholders alike, but ultimately the robustness of the system is diminished.”
What could knock it over? I don’t know. But I imagine we’ll soon find out.