Swimming Naked?

December 28, 2017

Swimming Naked?

  • The rising tide has really lifted all boats, but it’s extremely important to dive deeper and see who is swimming naked.
  • This will allow you to protect yourself from extreme downside and to potentially also earn something with some cheap hedges.
  • There are companies with no organic growth that have price to earnings ratios of 500…



Introduction

It will soon be nine years that we have been enjoying a rising economic tide. Economic policies around the world are still accommodative, and corporations really don’t have difficulties in finding financing.

However, if you have been through economic kindergarten, you know that the only thing sure in economics is cyclicality. Therefore, it’s important to see who will be swimming naked when the tide shifts, how to be protected from such a possibility, and perhaps even how to take advantage of it.

The most probable tide shifting in 2018 could happen in two ways. One is in the form of tighter financial conditions, higher interest rates, and perhaps higher inflation. The second is in the form of an economic slowdown which leads to higher unemployment rates, foreclosures, and some form of deleveraging that eliminates those businesses that are currently alive just because of easy money.

Let’s look into what can happen, and how to gain protection or even make money from the situation.

Scenario #1: Higher Interest Rates, Inflation

The FED is planning to increase interest rates three times in 2018. This means that toward the end of December 2018, we could see a Federal funds rate of 2.25%.

The current rate hikes haven’t yet had a significant impact on all interest rates, but much higher rates will inevitably increase interest payments for companies. The current U.S. high yield interest rate—where high yield is just a Wall Street nickname for junk bonds because high yield is much easier to sell than junk—is at 5.82% and not far from the historical lows hit in 2013 and 2015 thanks to quantitative easing.

Figure 1: U.S. High yield is at historical lows but usually jumps at the first sign of trouble. Source: FRED.

If you think that a 5.8% yield is too low as the average for corporations with a junk credit rating, you shouldn’t look at Europe where the effective yield on junk credit is just 2.6%.

Figure 2: European high yield rates show the incredible distortion in credit markets. Source: FRED.



For me, it’s obvious that corporations with a junk credit rating are really swimming naked here and if we see higher interest rates in the U.S. due to the FED’s tightening, and why not even in Europe due to higher global inflation, stocks with a junk credit rating or close to it would really suffer.

It isn’t that these companies wouldn’t be able to pay the higher interest, but the problem that few see now is that it’s about sentiment not actual interest payment capabilities. When the market stops believing that every junk bond is backed indirectly by central banks, fears of default will rise and consequently the market will get extremely tight. Further, such an environment would not only make it more difficult for companies to borrow, but also their current bond values would collapse.

A required yield of above 20% isn’t something unusual in the junk corporate bond market. It happened in 2009 and in 2002.

Figure 3: Long term European and U.S. junk yields often hit 20%. Source: FRED.

Now if you look at corporations, the problem is that many that don’t even have a junk credit rating can get one very quickly if things deteriorate in the business or the sector. For example, a company like Teva Pharmaceuticals was given a junk credit rating as soon as it got into trouble and the cash flows weren’t as high as expected. The junk credit rating just made it more difficult for Teva to survive.

To show an example of how a company with an A credit rating can be severely exposed to interest rate risks, I’ll use Caterpillar.

Caterpillar’s yearly interest cost is around $500 million which is more than 60% of the company’s trailing net income. Now, if interest rates rise by 50% as the FED is planning, Caterpillar’s long-term financing costs could quickly jump to $750 million which wouldn’t leave much for dividends, its credit rating would deteriorate, and the dividend could be in danger.

It might sound crazy for a company with an A credit rating, but those things move extremely quickly. A scenario that would further compromise the situation is a recession.

Scenario #2: Recession

My 21-year old cousin just got a new job as a junior human resources manager for a fitness chain that is 7 years old. Given the extremely low unemployment rates and consumer confidence levels, businesses like fitness chains can show relatively good growth numbers and therefore have access to capital.

For example, Basic Fit—a European fitness chain that went public in 2016—has a market capitalization of over one billion even though the total revenue over the first nine months of 2017 was €238 million and the net income was €2 million. The company is growing its revenue by 26%, but has also increased the number of fitness clubs by 27% which shows negative comparable sales. Nevertheless, what the company reports is all just great news.

Figure 4: All nice cool numbers for Basic Fit in their reporting. Source: Basic Fit.



Such companies will be extremely badly hit when the next recession comes as a PE ratio of 500 can’t justify 26% growth and no organic growth.

How To Protect Yourself & Even Make Some Money

The easiest way to protect yourself is to avoid holding companies with questionable cash flows and high debt burdens that only seem manageable just because of the low interest rates.

All the cyclicals with high debt levels will be badly hit so if you want to avoid extreme downsides, avoid such companies. Further, if you want to be hedged or try to trade on the above, I wouldn’t really go short as the risk is too high but buying long dated out of the money put options could be a very cheap hedge option.



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