Debt can be very helpful or hurtful. In business, debt is called leverage for a reason. It can grow a business and increase earnings. But misusing debt can turn that leverage into an anchor.
James Montier at GMO points out the misuse of debt to fund share buybacks (along with a few other things) and how it relates to the current market prices, in his latest paper Six Impossible Things Before Breakfast.
The debt for buybacks issue has been pointed out numerous times before, but it’s been largely overlooked or ignored. Buying back shares is a short term fix to show “growing” earnings per share. If you’re just looking at this on the surface, earnings per share is higher. Everything’s great, move along.
But this is grade school math:
earnings per share = earnings/outstanding shares
If the numerator – earnings – doesn’t change and you shrink the denominator – outstanding shares – the result is higher earnings per share.
The byproduct of historically low-interest rates was the push to take on cheap debt to buy back shares. Companies took on debt to lower the denominator.
Not all companies choose this path. Some actually used debt to grow earnings the old fashioned way. They grew the business and a higher numerator – earnings – was the result. The concern – that not many seem to be concerned about – is how more debt impacts the companies that didn’t. Here’s Montier:
So, if buybacks are a large part of the EPS growth that we have witnessed over recent years, then the natural question to ask is, “Is such behavior sustainable?” I would suggest not. Clearly, the consequence of a massive debt for equity swap is rising leverage at the corporate level…Here we see that leverage is approaching all-time highs once again. This creates a systemic weakness, or fragility, if you will. As Minsky outlined in his financial instability hypothesis, stability begets instability. Low rates allow debt issuance, and equity repurchases help line the pockets of corporate managements and (participating) shareholders alike, but ultimately the robustness of the system is diminished.
Here, history is our guide. It offers a wide range of outcomes when companies take on too much debt. A few could go belly-up and be a blip on the economic radar. Or many could get hit and result in a recession.
A recession is bound to happen eventually. Trying to figure out the why and when, before it happens is beyond my abilities. Montier, at least, offers a different viewpoint to consider. Besides, being prepared for a different outcome is more important than trying to figure it out.
GMO: Six Impossible Things Before Breakfast
- Greatest Investment Mistakes: Following a Single Source – Morningstar
- Gambling is a Feature of Capitalism, Not A Bug – Prospect
- Risk is How Much Time You Need – M. Housel
- The Enduring Wisdom of a 1972 Book About Tennis – Science of Us
- The Full See’s Candies Story: People & Product – Intelligent Fanatics Project
- Automation is Set to Hit Workers in Developing Countries Hard – The Outline
- The Arrival of Artificial Intelligence – Stratechery
- Cars and Second Order Consequences – Benedict Evans
- Amazon’s Ambitions Unboxed: Stores for Furniture, Appliances and More – NY Times
- ESPN Has Seen the Future of TV and They’re Not Really Into It – Bloomberg