The Next US Financial Crisis: The Problem with Expensive Stocks and High Leverage

Our recent piece Debt to EBITDA Ratios: The Spiral Higher Continues documented the explosive growth in leverage using aggressive accounting to fund deals. This piece intends to expand upon that work in the following ways:

Use data to highlight the hazards we see in the corporate debt bubble in public non-financial stocks
Explain the choice of “6x Total Debt-to-EBITDA” and our subsequent shift to “6x Net Debt-to-EBITDA”
Hone in on the record number of stocks with high debt and valuations with no precedent for positive performance in history

We get it: we are out of touch with today’s markets and the endless multiple expansion. We don’t understand why others are not alarmed by an “anything goes” attitude towards record levels of leverage where interest expense cannot be paid for by profits. As documented in our brief post, Stocks vs. Bonds, the world is awash in financial alchemy. Since 2007, a big part of America’s debt crisis has moved from the financial sector to non-financial stocks with too much debt.

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KCR’s research team believes that the mix of record debt and record equity valuations is likely a side effect of real rates approaching the record lows last seen in 1973. Whether we are right or wrong on the causality, the facts are intimidating in our view. Our research has documented that the world has never been less prepared or less equipped to deal with a possible outbreak of inflation or pull-back in Federal largess.

In a recent rant, we revisited Michael Lewis’ superb article Beware of Greeks Bearing Bonds. In that piece, we noted the US federal debt and budget deficits had stumbled into a situation very similar to the one that preceded the collapse of Greece. We are not suggesting the US is Greece or that what happened to the Greeks will happen to the US. Rather, we are merely observing that the US now looks and acts much like what was, in 2010, seen as the poor behavior of an irresponsible government of a small EU member.

Figure 1 below shows the growth in total debt of non-financial firms as a percent of GDP. Financial repression and low rates have led to an explosion in borrowed money. Corporate America has never owed this much. The Debt Crisis in American Equities

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Stocks and the Debt Crisis: How Much Corporate Debt is Too Much?

We understand that there will be those who highlight that some portion of the epic debt issuance was to build cash. As the world staggers back from the Covid virus, it makes sense for companies to issue cheap long-term debt and hold surplus cash when the world’s central banks make doing so uncommonly cheap and easy. Investors would rather companies borrow when debt markets are lax, interest rates low, and bond prices high.

Yet, Figure 2 shows that even adjusting for the cash retained on balance sheets, net-debt, has never been this high. Again, corporate America has never owed so much money. We believe that as long as the market-clearing price of money is suppressed by the Fed, it seems unlikely this trend will abate^[1].

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Kailash Capital Research, LLC ’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias. L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

ADDITIONAL READING

The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra reading for anyone seeking out more information related to the topics above.

SOURCES

^[1] For a chart of TOTAL DEBT, not scaled by GDP, click HERE

^[2] The Forbes article we have linked here by John Jennings is a brief but fantastic summary of this effect for those unfamiliar with it.

^[3] Leveraged Lending: Guidance on Leveraged Lending, March 22, 2013

^[4] Federal Register, Vol. 78, No. 56, Notices, March 22, 2013, 17773

^[5] IBID, 17771

^[6] IBID, 17771 – 17772, “Transactions where the borrowers Total Debt/EBITDA or Senior Debt/EBITDA exceed 4x EBITDA or 3x EBITDA, respectively, or other defined levels appropriate to the industry or sector.” KCR notes these leverage multiples are far lower than the 6x “all industry” caution flag we are using in this paper.

^[7] Federal Register, Vol. 78, No. 56, Notices, March 22, 2013, 17775

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