Tuesday, March 31, 2020

A Viral Market Meltdown V: Back to Basics!

My first post on this blog was on September 17, 2008, a week into the 2008 crisis, and I honestly did not expect to be posting for long, anticipating that after a few posts, that crisis would be behind us, and that we could go back to our lives. That of course turned out not to be the case, as the crisis not only extended for months, but left its imprint on almost everything market or economy related for the next decade. Almost twelve years later, and six weeks into another market crisis, I have a sense of deja vu, as the days of volatility stretch into weeks, and each week brings new surprises. Unlike my four previous updates, this one will describe a week of market recovery, at least in sum, but like the previous weeks, the increase in market values came with wide swings, and continued uncertainty and volatility. It was also a week that saw governments around the world rush to pass rescue packages designed to get both individuals and businesses through a period where the global economic machine has been shut down. These bailouts, in addition to being many times larger than prior bailouts, have also reignited debates about what governments should be demanding in return. In the United States, a central issue that is being argued is how much stock buybacks done by companies in the last decade are contributing to the pain that companies are facing, and whether there need to be restrictions on them. While I will consider this issue in depth in a post later this week, I will look at the interaction between dividends, buybacks and market damage in this post.

A Macro Review
As in prior weeks, I will start this week's post by updating how the different asset classes performed last week, partly to put the six-week period (from February 14, 2020 - March 27, 2020) in perspective and partly to get a sense of where we are going next. The place to start is with equities, and in the table below, I look at the changes in equity indices across the world, both in the last week (March 20 -  March 27) and the last month.
Download data
Markets around the world had a good week, with the US and Japan delivering the most positive returns. Even those solid weekly returns were insufficient to make up for an otherwise painful month, where most indices lost 20% or more of their value. Moving on to US treasuries, in a week where the Fed continued to aggressively support the market, rates dropped across maturity classes, with treasury bill rates again hovering around zero. The ten-year rate ended the week at 0.72% and the 30-year rate at 1.29%
Download data
As in the previous week, stocks and bonds moved together, albeit with positive, not negative, returns. The  positive mood in the equity and treasury markets spilled over into the corporate bond markets, where default spreads that had spiked in the previous week dropped during the week, as default risk fears subsided strongly for the higher ratings and mildly for the lowest ratings.
Download data
Moving on to oil and copper, the two commodities that I reported on last week, it was a week of divergence, with copper having a flat week but oil continued its fall, as Russia and Saudi Arabia tried, but failed to reach a detente.
Download data
Finally, I look at gold and Bitcoin, my stand-ins for crisis assets and both gained for the week, though Bitcoin had a much larger deficit to make up, from its drop in prior weeks.
Download data
All in all, it is telling that last week, with all its volatility, felt calmer than prior weeks, perhaps because more of it was on the upside and it is all relative. That said, we are still on a roller coaster and there are more thrills to come in the coming weeks.

Equity Market Breakdown
In keeping with my practice in prior weeks, I will break down the equity movement last week by region and sector first, looking to see if there are divergences. I begin by breaking down the change in market value, in both dollar and percentage terms, by region during the 3/20-3/27 week:

In the aggregate, Japanese stocks had the strongest returns this week (3/20-3/27), followed by US and UK stocks. In fact, last week was the strongest week for US equities since the 1930s, with stocks up more than 10% for the week. Globally, stocks added $5.7 trillion in market cap, but remain down $21 trillion since February 14, 2020, even with that revival. Moving on to sectors, and looking at the same metrics, I get the following:

The results here are consistent with the earlier findings that corporate bond default spreads declined last week, after the surge in the prior one, and the most highly levered sectors (real estate and utilities) benefited. Updating the list of the ten industries that have been hurt the most and least during this crisis (dating back to February 14, 2020, I get this list:
Download full list of industries
Some of the worst performing industries over the six-week period had the best weekly performance last week, but remain deeply damaged.

In previous weeks, I have looked at classes of stocks, focusing on a different dimension each week. in the first two weeks, I looked at stocks classified based upon growth/value (with PE standing in as proxy) and momentum (based upon the stock performance in the year leading into February 14, 2020) and found little differentiation in market damage across the classes. Put simply, there is very little evidence, at least during these six weeks, that the market is punishing high growth stocks or high momentum stocks more or less than other stocks. In last week's update, I noted that companies with high financial leverage were more exposed to damage at least during the week than less levered companies. In this week's update, I focus on another variable that people have pointed to, often with nothing more than anecdotal evidence, as a potential culprit  in the crisis, and that is stock buybacks. Their argument is that companies that have bought back stock, often with borrowed money, are the ones that have led us to the precipice, and that the viral shock to the economy is just a tipping point for these companies. To test this hypothesis, I classified global companies into those that bought back stock last year and those that did not, and looked at the market damage across the two classes:

It is true that companies that bought back stock last year were slightly more exposed to market damage than companies that did not, but the differences are small. Globally, buyback-companies have lost about 25% of their market capitalization between February 14, 2020 and March 27, 2020, whereas non-buyback companies have lost 21% of their market capitalization; for US companies, the analogous numbers were 26% for buyback-companies and 23% for non-buyback firms. To see if it was buybacks that were the drivers of this difference, I also classified firms into those that paid dividends in 2019 and those that did not, and got results very similar to the ones with the buyback categorization.
Companies that paid dividends suffered more market damage of almost the same magnitude as the the buyback companies did, suggesting that the old value investing adage of buying companies with big dividends is providing little solace in this crisis. 

Finally, I returned to buybacks and focused just on US companies, where the buyback phenomenon has been most pronounced, but looked at the cross effect of leverage and buybacks, to test the proposition that it is not buybacks per se that are the problem, but buybacks by companies that either already carry high debt loads or borrow money to fund the buybacks:

There are two groups, where buybacks make a discernible difference on returns. The first are companies with negative EBITDA that bought back stock (which strikes me as foolhardy), with market values dropping about 31% from 2/14/20 to 3/20/20, relative to negative EBITDA companies that did not buy stock, where market values dropped only 24%. The second is in the companies with the least debt, where market values for buyback companies declined  26%, as opposed to 16% for non-buyback companies. All in all, while it is true that some of the companies that are the recipients of government bailouts have bought back stock in past years, there is little evidence for the proposition that without the buybacks, they would not need the bailouts. I know that I am giving short shrift to buyback arguments, for and against, but I will return to this question, with a more in-depth breakdown in a post later this week.

Back to Basics
As with all of my viral update posts, I will end with a focus on the future and a return to fundamentals, by looking at how to value companies in the midst of a market and economic crisis unlike any in history. While many investors have put their valuation tools away, using the argument that there is too much uncertainty now to even try, I will argue that this is exactly the time to go back to basics and try valuing companies, uncertainty notwithstanding.

The Dark Side beckons..
If your concept of valuation is downloading last year's financials for a company into a spread sheet and then using historical growth rates, with some mean reversion thrown in, to forecast future numbers, you are probably feeling lost right now, and with good reason. Specifically, the last six weeks have upended almost all of the assumptions, explicit and implicit, that justified this practice.
  1. Historical data may be recent, but it is already dated: For most companies globally, the most recent financial statements are for 2019, and in calendar time, these financials are only a few weeks old. As the global economy shuts down, though, the one thing we know with certainty is that the revenues and earnings numbers reported in those recent financial statements are almost useless, a reflection of a different economic setting. The same can be said about equity risk premiums and default spreads, as I am painfully aware, since the numbers that I updated on January 1, 2020, are so completely out of sync with where the market is today that I plan to do a full update at the end of today. (March 31, 2020).
  2. This year will deliver bad news: There is almost no doubt that 2020 will be a bad year for all companies, with the key questions being how much of a drop in revenues companies will see this year, and how this will translate into earnings shocks. It is true that there are a handful of companies, like Zoom, Slack and Instacart, to name just three, that may actually benefit from the global quarantine, but they are the exceptions. 
  3. Survival has become a central question: The magnitude of the shock to corporate bottom lines and the speed with which it has happened has put companies at risk, leaving debt-burdened and young companies exposed to default and distress. While some of the largest may get help from governments to make it through this crisis, their smaller and lower-profile peers may have to shut down or let themselves be acquired.
  4. The post-virus economy will be different from the pre-crisis version:  Every major crisis creates changes in business environment, regulations and business models that reshapes the economy and resets competitive games, setting the stage for new winners and losers. Thus, for some companies, the bad news on revenues and earnings this year may be a precursor to superior operating performance in the post-virus economy, as their competition fades 
Put simply, this is not the time for purely mechanical number crunching and a blind trust in mean reversion, since the landscape has changed. It is also not a time to wring our hands, complain that there is too much uncertainty and argue that the fundamentals don't matter. If you do so, you will be drawn to the dark side of investing, where fundamentals don't matter (paradigm shifts, anyone?), new pricing metrics get invented and you are at the mercy of mood and momentum. Ironically, it is precisely at times like these that you need to go back to basics.

A Jedi Guide to Valuation
With these lessons in mind, I decided to revisit my basic valuation model, which has always been built around fundamentals:

While the fundamentals remain the same, I considered how best to incorporate the effects of this crisis into the model and arrived at the following:

Note that this post-Corona valuation model stays true to the fundamentals but introduces three crisis-specific inputs into the valuation:
  1. Revenue Change & Operating Margin in 2020: These are the inputs that will reflect the effects of the global economic shut down on your company's revenues and operating margin in the next 12 months. For companies close to the center of the viral storm (travel-related companies, people-intensive businesses and producers of discretionary products), the revenue decline this year will be large and they will almost certainly lose money. (See my third viral market update for a way of visualizing this damage)
  2. Expected Revenue Growth in 2021-2025 and Target Operating Margin: If you feel drained from having to estimate the 2020 number, I don't blame you, but the more forward-looking part of this valuation is estimating how your company will fare in the post-virus economy (assuming it does not fail). For some companies, like cruise liners, the answers will be depressing, because the sights of large cruise ships stranded on the high seas, and acting as Petri dishes for spreading diseases will linger, but other companies will find themselves in a  stronger position in  the post-viral economy, partly because of their product offerings but also because of their financial strengths. In the tales told about Amazon, people often forget how much its current stature and success is due to the dot com bust (not the boom) of 2001, which wiped out their online competitors and handicapped their brick-and-mortar competitors.
  3. Failure probability and consequences: In good times and when valuing mature companies, we become lazy and forget that conventional valuation approaches, where you project cash flows as far as the eye can see and beyond, and discount them back at a risk adjusted discount rate, are designed for going concerns. These are not good times, and even mature companies are facing threats to survival. It is almost impossible to adjust for this concern in discount rates and it is therefore imperative that you make judgments about the likelihood that your company will not make it, and this probability will be higher for smaller companies, young companies and more indebted companies. Even with large companies that may be recipients of bail outs, because they are too big to fail, your equity may go to zero, if that is one of the conditions of the bailout (as was the case in the 2009 GM bailout).
I have updated the equity risk premiums (not only for the US but the rest of the world) to reflect the market convulsions over the last few weeks, as well as default spreads for debt, and suffice to say that there has been a surge in the price of risk.  I know that that you are trying to make a judgment call in a period of incredible volatility, where no one (managers, analysts, governments) know what is coming,  but your reasoned guess is as good as anyone's estimate. So, be bold, make your best estimate and move on! If you get a chance, you may also want to watch this video guide I put together last Friday for using my spreadsheet:
I value Boeing in the webcast but rather than focus on my story and valuation of the company, please focus on the process, so that you make it your own. There is nothing magical in the spreadsheet, and I am sure that there are flaws in it and that you can make it better. Use it as a starting point, adapt it and make it better.  Carpe diem! 

YouTube Video

Data Links

  1. Macro Market data (stocks, bonds, commodities, gold) on March 27, 2020
  2. Industry Breakdown on March 27, 2020

  1. A Post-Corona Valuation spreadsheet (with a video guide on how to use it)

Monday, March 23, 2020

A Viral Market Meltdown IV: Investing for a post-virus Economy

At the end of each of the weeks leading into the last one, I have done a market update, reflecting the changes that occurred in the week, not just to market values, but also to investor psyches, and each week, I have hoped that it would be the last one needed for this crisis. That hope was dashed last week, as markets continued on their downward spiral, and here I am again, writing another viral market update. In this week's update, I will begin by again first chronicling the market damage, across asset classes, and within equities, across sectors, industries and company types, but I will follow up by looking at four different investment strategies for those who have the capacity and the willingness to look past the near term, recognizing that many of you might not have that luxury.

Surveying the Market
In what has now become a common component of each of these weekly updates, I will start with a survey of overall market performance in different asset classes, and  and then break down the damage in equity markets across the globe.

The Macro Picture
As was the case in 2008, it was difficult, perhaps impossible, to find a safe place to hold your money last week and no market was spared during the week. It was a week when equities lost trillions in value, across the world, but it was also a week when treasuries that had appreciated in prior weeks due to a flight to quality also saw no gain, oil continued its falls to multi-decade lows, and gold did not play its historic role as a crisis asset. Let's start with equities. The week started badly and did not get much better, as fear ruled across markets:
Download spreadsheet
The European equity markets, at least collectively, did better than the American and Australian markets between March 6 and March 13, with the Asian and African markets falling in the middle. When equities are in free fall, US treasuries are usually the beneficiary, but last week proved to be an exception, as treasury rates at the long end stabilized, perhaps spooked by the prospect of inflation from the trillions of dollars in rescue packages being proposed:
Download spreadsheet
The fears that this crisis will create an extended and deep recession, which, in turn, will cause corporate defaults to rise, especially in natural resource and travel-related companies, caused corporate bonds to have their worst week of this five-week crisis period:
Download spreadsheet
The damage in the corporate bond market, not surprisingly, was worse for lower-rating bonds, but the even highest rated bonds were not spared. Speaking of natural resource companies, oil continued on its downward trend, falling well below what many analysts had pronounced as its floor:
Download spreadsheet
The fact that copper, another commodity sensitive to global growth, has not dropped as much shows how much of an effect the Russia-Saudi tussle is having on oil prices.  Closing off, gold had a better week than stocks, but it too was down, but bitcoin ended the week on a little bit of an upswing.
Download spreadsheet
All in all, no asset class was safe and creative asset allocation would have best reduced the pain, not eliminated it.

The Breakdown
As in the weeks before, I will take apart the drop in equities around the world and look at the differences meted out, both in the last week and cumulatively over the five weeks since February 14.

Sector and Industry
I start by looking at the loss in value, broken down by sector, with the percentage changes in value computed over a week and over five weeks:
Energy remains the most damaged sector, with financial services and real estate close behind., and  consumer staples and health care have held up the best. Breaking the sectors down to industries, and looking at the ten best and worst performers last week:
Download spreadsheet
The industries that were worst hit were infrastructure companies (with the exception of healthcare support services and automotive retail) that tend to have debt. Read in conjunction with the earlier table on the widening of default spreads for corporate bonds, last week's market collapse seems to have been driven more by default risk concerns than the prior weeks. The least affected businesses tend to be those that cater to non-discretionary demand.

Earlier in this post, I looked at market indices around the world to conclude that stocks listed on the American and Australian continents were more affected than European stocks. Expanding on that proposition, I look at the market value lost, both in dollar and percentage terms, across regions:
Globally, companies have lost $26.1 trillion in market capitalization over the last five weeks, and US stocks alone have lost $11.8 trillion in market cap. Canadian, Australian and Latin American stocks have been worst hit, in percentage terms, and China and the Middle East have taken the smallest hits, in percentage terms.

Net Debt and Profitability
It looks like debt concerns rose to the top of the worry heap last week, and to see how this shows up at the company level, I broke companies down into five quintiles, in terms of net debt ratios, and five quintiles in terms of operating profit margins. Specifically, I want to see how much having a profit buffer and low debt has protected companies during this meltdown. 

I apologize if this table is a little overwhelming, but the way to read it to look at the combinations of net debt and profitability. For instance, companies with the least debt are in the bottom quintile of the net debt column and companies with the highest profitability are the top quintile of the profitability column. I don't want to read too much into this table, but if you look at last week's action, stocks with lower net debt ratios (in the bottom two quintiles) did much better than stocks in the top debt quintile.  At least for the moment, the profitability effect is being drowned out by the debt effect, since there is little discernible relationship between operating profit margins and market markdown. If you squint hard enough, you may be able to find something, especially in the middle quintile, but I will leave that up to you.

Looking Past the Crisis
In one on my first posts on this viral market crisis, I mentioned that the first casualty in a crisis is perspective. As you get deeper and deeper into the specifics of the crisis, you will find yourself not only getting bogged down in numbers, and in despair. I have had moments in the last few weeks, when I have had to force myself to step back from the abyss, think about a post-virus world and to reclaim the initiative as an investor. If you are a pessimist, you may view this as being in denial about what you see as an economic catastrophe that is about to unfold, but I am a natural optimist, and I believe that this too shall pass!

The Economy
There is no disagreement that the virus will cause the economy to go into a deep recession, since commerce is effectively shut down for at least a few weeks. During that period, economic indicators such as unemployment claims and measures of economic activity will hit levels not seen before, bur that should come as no surprise, given how large and broadly based the shock thas been. There are two questions, though, where there can be disagreement.
  • How quickly will the global economy come back from the shut down, and when it does how completely will it recover?
  • How much permanent change will be created by this crisis in terms of both consumer (and investor) behavior and economic structure?
There are some who are more optimistic than others, arguing that once the viral fears disappear, there will be a return to business as usual for most parts of the global economy, stretched out over months rather than years, and that the changes to consumer behavior and economic structure will be small. At the other end, there are many more who feel that economies take time, measured in many years,to recover from shocks of this magnitude and also that there will be significant changes in consumer behavior and economic structure in the making.

Investment Strategies
Your views on the economy, both in terms of how quickly it will come back from this shock and how much change you see in economic structure, will determine your next steps in investing. If you believe that recovery will be quicker and with less structural change, there are two strategies you can adopt. 
  • Bargain Basement: In this strategy, you focus on stocks that have been pounded in the last few weeks, losing 50% or more of market value, but which have the ingredients that you believe will allow them to survive, perhaps stronger, in the post-virus economy. Key among these ingredients will be low net debt ratios (Net Debt to EBITDA less than one) and pre-virus  operating margins that were solid enough to take the hit from the crisis. To the extent that survival until the turnaround occurs is key, you may also keep your search restricted to larger market cap companies.
  • Distressed Equity: There is a more risky strategy you can adopt, where you also look for stocks that have seen a significant loss in value over the last five weeks, but focus on the most endangered of these, with high net debt and fixed costs. You are effectively buying options, with some already out-of-the-money, and as with any strategy built around doing that, you will see a significant number of your investments go to zero. The payoff from this strategy comes the companies that make it back to life, with equity values increasing by enough to cover your losses. At first sight, the airlines and Boeing meet these criteria, but there is a catch, insofar as they are large enough to be targeted for government bailouts, which are a mixed blessing, since they allow companies to survive, while wiping out or severely constraining equity claims. Thus, smaller companies that have to make it through on their own may be better candidates  for this strategy than companies that are too big to fail, that attract large bailouts. 
If you are more pessimistic about economic recovery, both in terms of its length and strength, and believe that the recovery will restructure the economy and how companies operate in many businesses, there are two strategies that you may find work for you:
  • Safety at a Reasonable Price (SARP): Here, you focus on companies that are best positioned to not just survive a long downturn, but have the ammunition to make it work to their advantage. Large market cap firms with low debt ratios and high cash balances, that had high growth and profit margins in the pre-virus economy, would be good candidates. Facebook, Alphabet, Apple and Microsoft, for instance, clearly fit these criteria, but  since these companies are already sought after in a market where safety is rare and highly valued, you should add pricing screens that allow you to get them at reasonable prices. 
  • Change Agents: This is as much a bet on changes in consumer behavior and economic structure as it is on individual companies. Thus, if you believe that this crisis will make people more comfortable with delivery services for a wider range of goods and online interaction (in business and education), you could seek out companies that are innovators in these spaces. Again, the highest profile players, like Zoom, may be priced out of your reach, but there are others like Chegg that may meet your criteria.
The picture below summarizes the four strategies:

My views on the economy are mixed. I do think that the global economy will come back, but it will take more than a few months, and there will be structural changes in some sectors. I ran screens for all of the strategies, other than the Change Agents strategy (which is less about screening, and more about detecting macro trends), across all publicly traded stocks (about 40,000+) on March 20, 2020. As I look at the companies that go through the screens, I realize that there is more work to be done and better screens that can be devised, but think of it as work in progress, and if you have access to a large database, try your own.

YouTube Video

  1. Market Changes by Asset Class, through March 20, 2020
  2. Market Changes by Industry, through March 20, 2020
Screened Stocks
  1. Bargain Basement, as of March 20, 2020
  2. Distressed Equity (Options), as of March 20, 2020
  3. Safety at a Reasonable Price (SARP), as of March 20, 2020 (Add your pricing screen)

Saturday, March 21, 2020

Data Update 7 for 2020: Debt Delusions and Reality

In the midst of a crisis, it is very difficult to think about life in its aftermath, but there will come a time, when investors and companies will shift their focus. To be able to do so, they have to survive the crisis, and for many companies, that has become the immediate challenge. In the last post, I looked at one factor that will determine survival risk, and that is the buffer than companies have on growth, profitability and reinvestment, with companies in higher margin businesses being more protected than companies in businesses with slim or negative margins. In this one, I look at the other factor that will determine survival and that is the debt burden on firms, since companies with higher debt burdens, other things remaining equal, will be more exposed to failure and distress than companies without those burdens.  I will look at the degree of indebtedness of companies around the world, broken out by industry and region, partly with an eye on assessing how much danger they are exposed to right now, as their near term business prospects collapse, and partly to see which firms, industries and regions are best positioned to make it through this crisis.

The Debt Trade Off
The question of how much a firm should borrow is one of the three questions that comprise corporate finance, but there are a number of delusions about debt that need to be dispelled first. The picture below, that I also used in last year's debt update captures what I term the "illusory benefits" of debt:

Thus, the argument that borrowing money lowers your cost of capital, just because it costs less to borrow than to raise equity, does not hold up, since the risk from the investments taken with the capital raised remain unchanged, no matter what the debt mix. The counter argument that you should never borrow money, since borrowing money will lower your net income, misses the fact that borrowing money to fund a company leads to fewer shares outstanding.

The real trade off on debt is determined by the tax benefits that are endowed on debt by tax law in much of the world, with interest expenses being tax deductible and cash flows to equity not, and the offsetting effects of expected distress costs, low for firms with stable, predictable earnings and in good economic times, and high for firms with more unstable earnings and more unstable economic settings. There are a couple of secondary factors, with debt acting as a mechanism to keep managers from taking investments that are bad enough to put the company's survival (and management jobs) at risk and the costs associated with managing the conflict of interests between stockholders and bondholders.
This trade off, intuitive and simple, can be a powerful device for making predictions about what should happen to the use of debt over time. In the United States, for instance, the corporate tax reform act of 2017, in addition to lowering the federal corporate tax to 21% from 35, also put limits on interest deductions, thus making debt significantly less beneficial to companies. Even before this crisis hit, there were questions about whether a long stretch of good times for companies had made them too complacent about distress risks and expected bankruptcy costs, and now after the crisis, there is no debating that many companies have too much debt, given near term earnings and perhaps even long term earnings.

The Debt Burden
As companies scramble to get out from under their debt burdens, they will face challenges, and to see the magnitude of the tasks they face, I will chronicle how much debt was held across the world at the start of 2020. I will also break the debt down by region, and by industry, to see how steep the climb will be for companies, and to assess which sectors have the largest capacity to withstand the earnings shocks that are sure to come.

Defining Debt
As a prelude to assessing the debt burden at companies, I want to start by deciding what to include in debt. For those who trust accountants, this may seem redundant, given that there is a debt number listed on balance sheets, reflecting what companies owe at least on the date of the statement. As someone who does not share that trust, I use a two-part test to determine whether to include a claim in debt or not:
  1. Does the claim give rise to a contractual commitment that you have to meet in good times and in bad? 
  2. If you fail to meet that commitment, are there consequences that result in the business shutting down or assets being controlled by lenders?
To start, a bank loan or corporate bond clearly meets both requirements, with interest expenses and principal payments being contractual commitments, and failure to meet those can result in either default or loss of control over the business.
  • All interest bearing debt, short term as well as long term, floating or fixed, meets the requirements for debt. 
  • Accounts payable and supplier credit don't meet that test, because they do not have explicit interest expenses; to the extent that you get less favorable terms or lose a discount by using supplier credit, there are implicit interest expenses, and if you are willing to make those explicit, they can be treated as debt. 
  • All lease commitments are debt, though we can debate the maturity of the commitment (based upon escape clauses and renewal terms in the leases) and whether it is secured or unsecured debt. In fact, converting lease commitments to debt is a simple present value exercise, where the contractual commitments for future years are discounted back to today using the pre-tax cost of debt as the discount rate, a practice that I have followed all through my valuation years. Until 2019, accountants followed a misguided practice, allowing companies to categorize leases, based upon whether they had ownership of the asset, into operating and capital leases, with only the latter being treated as debt. In the process, operating leases became the biggest source of off-balance sheet debt for retailers, restaurants and other big lessees. In 2019, both GAAP (FASB 842) and IFRS (IAS 16) came to their senses and required companies to treat all leases as debt, creating a significant change in balance sheet debt at many companies. Later in this post, I will compare my calculations of lease debt to the accounting lease debt, to probe differences.
Debt Measures
There are different measures of the debt burden, with each measure serving a different purpose. Broadly speaking, these measures can either look at debt as a percent of the total capital invested in business or look at debt payments due, relative to earnings and cash flows of the company. The first becomes an input into hurdle rates and the latter becomes a measure of the buffer against downturns and crisis:

To the extent that having cash on your balance sheet offsets some of the debt burden, you can compute all of these measures, using net debt ratio (where cash is netted out against total debt) and net interest expenses (where interest income from cash is netted out from interest expenses). Note that the two approaches measuring debt can give different signals. Thus, a company can have a low debt ratio (as a percent of capital, in either book value or market value terms), an indicator of a low debt burden, while having dangerously low interest coverage ratios and high debt as a multiple of EBITDA. The table below captures the possible combinations:

Note that the predictably of revenues and earnings brings an additional dimension brought into the comparison. To the extent that some companies have more predictable earnings than others, because they sell more non-discretionary products and services, they are less exposed to risk than other companies, with similar debt burdens; a discount retailer with a debt to EBITDA multiple of four is safer than a luxury retailer with a debt to EBITDA multiple of four.

Interest Bearing Debt & Lease Commitments in 2020
I begin by looking at debt burdens, relative to both book and market capital, across the world. In making this assessment, note that I have done the following:
  • I have counted all interest bearing debt, as reported by the company, on its most recent financial statements. I use this book value of debt as roughly equivalent to the market value of debt, because much of the debt taken by companies taken by companies is in the form of bank loans, and there is no observable market value. While there are ways of converting book value of debt to market value of debt, they require inputs on debt maturity that are not available for many companies.
  • I have computed the lease debt, using lease commitments and an estimated cost of debt for each company, rather than trust the accounting estimates of this debt, at least for 2019. That is partly because the rule change applies only to those sections of the world that are covered by IFRS and GAAP and partly because I don't trust accountants yet, on this measure.
  • To compute the net debt, I subtract out the cash and marketable securities that the company reports on its latest financial statements.
  • Since debt to a financial service firm is more raw material than capital, and determining what comprises debt is almost an unsolvable puzzle, I have excluded banks, insurance companies and brokerage firms/investment banks from my sample.
Recognizing that the most recent financial statements for most companies in my January 2020 update are from September 2019 and with the even more important caveat that the market capitalization, while updated through March 16, 2020, is a moving target in a market like this one.
 Download spreadsheet
On a book capital basis, US companies have the highest proportion of debt, but relative to market value, Canadian companies have the most debt. Across global non-financial service companies, total debt is about 34% of market capital and 49% about book capital. Doing the same analysis across industries, again excluding financial service firms, the ten industries with the highest debt to market cap ratios and the ten with the lowest are listed below:
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Notice the preponderance of technology firms on the least levered list and the bunching up of infrastructure and manufacturing companies on the most levered list.  All of the numbers reported above for debt include my estimate of the lease debt, and since the accounting rule changes this year have brought lease debt on to balance sheets, I can compare my estimates to the accounting numbers. For non-financial firms collectively, my estimate of lease debt is about 60% higher in the aggregate that the accounting estimates, reflecting partly the additional information that accountants have on lease specifics that I do not, partly the fact that there are segments of the world where leases are still not treated as debt and partly the complexity of accounting rules on lease debt.

Earnings and Cashflow Coverage
As we noted earlier, companies that look lightly levered, when debt is measured against capital, can still face a significant burden if their earnings and cash flows are insufficient to meet debt payments. In the table below, I look at the regional differences on debt as a multiple of EBITDA and interest coverage ratios:

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With the caveat that the EBITDA and operating income numbers are from 2019 and do not reflect the damage that is going to be caused by the Virus, companies in Africa/Middle East and Eastern Europe have the least debt, relative to EBITDA, but Japanese companies have the most buffer, based upon interest coverage ratio. Canadian and Indian companies have the least buffer, on an interest coverage ratio basis. Extending this analysis to industries and looking at the ten industries with the most buffer and the ten with the least:
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While most of the firms in the most buffered list mirror the earlier ranking based upon low debt levels, the presence of integrated oil and oil production companies indicates how transient these buffers may be, since the dramatic drop in oil prices in the last few weeks will ravage the EBITDA and operating income numbers at these companies. Among the least buffered list are utilities, which may be able to weather the storm with stable revenues, and a number of real estate related industries, which will be exposed if real estate values drop. At the top of the list of the most exposed industries are investment and asset management companies, reflecting both their access to and use of debt to accentuate returns to equity investors.

Lessons from a Crisis
Every crisis teaches investors and companies lessons that are temporarily learned, but quickly forgotten. This one is a reminder to firms that debt, while making good times better for equity investors, makes bad times worse. For some of these firms, that debt will threaten their continued existence and result in liquidations, fire sales and distress. For others, it will create constraints for the near future on growth and investment, and change business plans. For firms that are lightly burdened, it may create opportunities, as they use their liquidity as a strategic weapon to fund acquisitions and to increase market share. If you were worried about winner take all markets before this crisis, you should be doubly worried now!

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  1. Debt measures, by region
  2. Debt measures, by industry
  3. Lease effects on profitability and debt measures, by industry

Data Update 6 for 2020: Profitability, Returns and the value of Growth

In an age, where scaling up and growth seems to have won out over building business models and profitability, as the most desirable business traits, it is worth stating the obvious. The measure of a good business is its capacity to generate not just profits, but also to convert these profits into cash flows that investors can collect. If we needed a reminder of this age-old premise, the last three weeks should have provided a wake-up call. In fact, if your central concern is about the negative economic consequences of the viral meltdown, in the short and the long term, higher growth and margin  companies will be best suited to not just survive them, but emerge stronger in the post-virus economy. In this post, I will try to look at growth, earnings and cash flows, and how they interact in value, and use that framework to examine how companies around the world, in different sectors, measure up. 

Growth, Profits and Cash Flows
The trickiest part of valuation is negotiating a balance between growth, profitability and reinvestment, with a plausible story holding them together, to derive value.
  • The Scaling Factor: Growth plays the 'good guy' role, allowing small companies to become big, and big firms to become even bigger.  While a growth rate can be computed on any metric, the metric that best reflects operating growth is revenue growth, accomplished by either selling more units or raising prices.
  • The Profitability Driver: Growth, by itself, can only scale up a firm's operations and revenues, but for that scaling up to pay off, it has to become profitable. Again, while there are many measures of profitability, scaling profits to revenues to arrive at profit margins makes the most sense.
  • The Reinvestment Lever: To grow, a company has to reinvest in capacity, in whatever form, and this reinvestment can drain cash flows. This reinvestment can be tied to earnings, as a retention ratio or a reinvestment rate, or to sales, as a sales to invested capital ratio.
If that sounds familiar, it is perhaps because you have seen me value many companies on this blog, using these three variables, added on to a risk component, to value companies as diverse as Kraft Heinz to Tesla to Beyond Meat. In fact, the cash flows that you observe for a firm can be captured by the interactions between these three forces, and those interactions let us differentiate between great, average and bad firms:

The extremes represent the best and worst possible combinations of these variables. Great firms pull off the trifecta, scaling up revenues with relatively little reinvestment, while deliver high margins. Terrible firms are saddled with the worst possible mix of low revenue growth, low or even negative margins and large capital investment requirements to deliver even their growth. The bulk of the business world falls in the middle, facing tradeoffs that determine value. Some trade off low margins for high growth, hoping that the dollar profits they deliver will be large enough, simply because of scale. Others are willing to reinvest more in the short term, to build barriers to entry and generate higher and more sustainable margins and returns for the long term.  In the rest of this post, I plan to look at how companies around the world measure up on each of these dimensions, beginning with the growth that they have recorded in the recent past, moving on to measures of profitability and ending with reinvestment numbers. I will then close by bringing in the hurdle rates that I estimated in my last post as benchmarks, to measure how firms measure up on value creation or destruction.

The first variable that I will look at is growth, and focus primarily on past growth in different metrics, ranging from revenues (the top line) to net income (the bottom line). Along the way, I will argue that the way growth rates are estimated and the periods used for the estimation can have large effects on the numbers that emerge, and that bias, as with everything else in valuation, can affect choices.

Growth Metrics
Investors often make the mistake of assuming that, since the past is behind the, a historical growth rate for a company is a fact, not an estimate. That is a myth, since the historical growth rate that is reported for a company is a function of multiple choices made on estimation, as can be seen in the picture below:

So what? First, it is worth remembering that that the biases an investor brings to the table will often determine how, and in what metric, growth is computed. In general, at least in good times, earnings per share growth will be the mantra of bullish investors in a stock, whereas top line growth will the number offered by more pessimistic about the stock. Second, if you are using growth rates for companies from a data service, it is always worth asking questions about the approach used to compute growth (arithmetic or compounded) and time period used (starting and ending years), since they can skew growth rates up or down.

Growth Rates - A Global Overview
In keeping with the theme that with growth rates, it behooves us to be transparent about estimation choices, I will start by explaining my choices when it comes to growth. For historical growth rates, computed at the start of 2020, I use the compounded average growth rate in the previous five financial years. For most firms in my sample, this is the geometric average growth rate from 2014, as the base year, to 2019, as the final year in the sample. I will also compute growth rates in revenues (top line) and net income (the proverbial bottom line). With the latter, there will no growth rates computed for companies that are money losing, since the growth rate becomes a meaningless number. With that lead-in, I start by estimating growth rates by industry group, and in the table below, I list the ten industries with the highest growth rate in revenues in the last 5 years (2014-19) and the ten with the lowest:
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Note that even before the crisis, oil companies were shrinking, computers/peripherals had close to flat sales, and software dominates the list of high growth businesses. For a full list of growth rates, by industry, please click here.  To see if there are differences in growth in different parts of the world, I then break down growth rates in revenues and net income, by region, between 2014 and 2019.
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Note that more than a quarter of all publicly traded firms saw revenues shrink, in US dollar terms, over the last five years, and that across all firms, the median growth rate in net income is much higher than the median growth rate in revenues, across all regions. However, the range on net income growth is wider than the range on revenue growth. Finally, it is worth noting that investing is based upon future growth, not past growth, and I use estimates of expected growth rate in earnings per share as my proxy. Notwithstanding the biases that analysts bring into this estimation process, it remains a forward-looking number, and I look at how expected growth in earnings per share varies across companies in different PE ratio classes:

While this data is too raw to draw big conclusions from, higher PE stocks have, not surprisingly, have higher expected growth rates than low PE stocks. As investors, though, that tells you little about whether high PE stocks are good, bad or neutral investments, since the enduring question becomes whether (a) the high expected growth reflects reality or hopeful thinking on the part of analysts and (b) the PE ratio fully, under or over reflects this expected growth rate. It is one reason that I remain wary of using pricing screens to pick stocks, since there is no short cut or formula, that will answer this question. That will require a deep dive into the company's business model and full forecasting of earnings, cash flows and risk, i.e., an intrinsic valuation.

Growth is only one part of the valuation puzzle, since without profits that come with it, it will be wasted. In this section, I will look at profitability across regions, sectors and subsets of stocks, again with the intent of eking out lessons that I can  to in corporate finance, investing and valuation. 

Margin Definitions & Usage
With profit margins, you scale profits to revenues, and as with growth, there are multiple metrics that can be used to compute margins, and which one is used is often a reflection of the biases that investors bring to the game. In the picture below, I look at a list of possible profit margins, and what each one is trying to measure:

By itself, each margin serves a purpose and tells a tale, and is worth calculating. Thus, the contribution margin measures the pure profits that you generate with every marginal unit you sell, since it nets out only the variable cost associated with producing that unit, giving many software companies close to 100% contribution margins. Gross margins are a close relative, providing a direct measure of marginal profitability and an indirect measure of how revenue increases flow into profits. To illustrate, Zoom, one of the few stocks that has seen its value increase during the crisis, reported a gross margin of 92% in 2019. Operating margins measure what is left after the other operating expenses of the company, which cannot be directly traced to individual unit sales, but are nevertheless necessary for its operations. Thus, R&D expenses and SG&A costs are netted out from gross profit to get to operating profit, yielding a measure that will capture economies of scale, as the company scales up. Netting out taxes and interest expenses, and adding back income from cash and cross holdings, yields net margin, a measure of what equity investors get to keep out of every dollar of revenues. It is a mixed and noisy measure, reflecting a company's operating model, its tax liabilities and its financial leverage (since debt creates interest expenses and affects taxes), as well as non-operating assets. Along the way, there are diversions. If you take the operating income, act like you have no debt and net the taxes you would have paid on that operating income, you get after-tax operating margin, a measure of operating profitability that takes into account taxes. If you take operating income, and add back depreciation and amortization, you get EBITDA margin, a measure of operating cash flows, before reinvestment. In recent year, companies with large stock based employee compensation have taken the tack that since it is in the form of shares or options, it is not an expense, and have added back this and other "extraordinary" expenses (with lots of leeway on what comprises extraordinary) to compute adjusted EBITDA margins that supposedly capture even better the cash flows at the firm. 

As you look at margins, whether reported by a company or computed by a third party (including me), here are some general principles to keep in mind. First, desperation drives a money-losing company up the income statement to use more expansive forms of margin. Notice that Microsoft, which has operating margins of close to 35% and net margins of 20% plus, never talks about gross margins, whereas some of Tesla's biggest promoters keep bring up the fact that its gross margin is 25%. Boasting that your gross margin is positive is akin to being on a diet and claiming that you consume only 1800 calories a day, but that is before you count the calories in the second courses at meals, desserts and snacks. Second, not all adjustments are created equal. I have long argued that while adding back depreciation and amortization to get to an EBITDA margin may be justifiable, adding back stock based compensation is not, since it is effectively using a barter system to evade cash flows. Put differently, you could have issued those restricted shares or options in the market, and used the cash to pay your employees, and chose not to.

Margins: A Global Overview
As with growth rates, I am going to begin by offering some background on the data that I use to compute my margins, and the adjustments that I make along the way. I use the revenues and income numbers from the trailing 12 months, which at the start of 2020, would give me the financials for most firms from October 2018 to September 2019. While that may seem short sighted, I have the archived numbers from the last decade on my website, for you to download and make your own judgments. Of course, with the market crisis fully upon us and a recession looming, you will be well served looking at the historical data. I start looking at margins across industries, to get a rough measure of how revenues flow through as earnings to the firm and its equity investors. In the table below, I list the ten industry groups with the highest and lowest operating margins, using global companies:
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Note that retail is particularly exposed in this crisis, simply because margins were low to begin with, though the question of how much will vary across retail. Thus, grocery and online retail may be more resilient than automotive and general retail from a prolonged shut down of commerce. Among the highest margin businesses, there are many that will see margins deteriorate very quickly from this crisis, with energy (both oil and green) showing the biggest near term hits. Real estate will also be exposed if there is a deep recession, but software, beverages and tobacco should see profitability hold up better. Looking across regions, I compute profitability measures across all companies in each region, recognizing that the industries that dominate each region be very different. 
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Note that the Asia had the lowest margins in 2019, a warning that high growth does not always translate into profitability. Conversely, Eastern European & Russian companies have high margins, albeit with low growth. African and Middle Eastern companies have sky high margins, reflecting domestic companies that dominate local markets with little competition.

Reinvestment Efficiency
If revenue growth captures the scaling up factor, and margins the profitability of a business, the last part of the story has to be about the efficiency with which the growth is delivered. For manufacturing companies, this will be captured in how much they spend in adding production capacity, and how efficiently they use this added capacity to produce more units. For non-manufacturing companies, the investment may be in research and development, acquisitions and other "intangibles", but it too is reinvestment and its payoff in growth affects value. For retail firms, it may take the form of inventory, accounts receivable and other ingredients of working capital, and how well they can manage these as they grow.

Reinvestment Efficiency:  Definitions & Usage
Unlike revenue growth and margins, which has widely accepted proxies and measures, reinvestment efficiency remains more of a smorgasbord of different measures. Broadly speaking, these measures scale how much capital is invested either to the operating income that is created, in returns on capital measures, or to revenues, by relating capital invested to revenue growth.

In sum, reinvestment in any period is defined broadly to include not just investments in plant and capacity, the accountant's traditional cap ex measure, but also working capital, acquisitions and investments in research and development and intangible assets.
Reinvestment = (Cap Ex - Depreciation & Amortization) + Change in non-cash Working Capital + Acquisitions + (R&D expenses - Amortization of R&D)
That reinvestment accumulated over time comprises the invested capital of the firm, and both numbers (reinvestment and invested capital) can be scaled to either after-tax operating income or to revenues. When margins are stable, the two approaches are equivalent, but when the margins are changing, the revenue-scaled measures become more useful.

Reinvestment Measures: A Global Overview
 I noted at the start of this post that "ease of scaling up" has become a central theme of young growth companies reaching into new and often very large markets. While this has always been a selling point for conventional software and technology firms, it has expanded its reach into other businesses, from Uber in car service/logistics to Casper in mattress sales. In essence, the selling point for these models is that they can reinvest much more efficiently than their established competitors, though their growth pitch is still more focused on sales than on profits. In this section, I report on investment efficiency numbers, staying true to my premise that reinvestment has to include acquisitions and R&D. To get a sense of how investment efficiency varies across industries, I computed sales to invested capital and returns on capital, across industry groups, and in the table below, I report on the ten most and ten least efficient industries, at least when it comes to delivering revenues for every dollar of capital invested. 
Looking at regional differences, again recognizing that the industry concentrations vary geographically, I find the following:
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Note that the concentration of natural resource companies in Australia, New Zealand and Canada, which lowered profitability, is also showing up as lower returns on capital. The more troubling number is the 4.55% median return on capital delivered by the median global company in 2019, not only well below the cost of capital globally, but also likely to see a major hit this year, as  the Corona Virus works through the global economy.

Excess Returns
I talked about risk and hurdle rates in my four earlier data posts, where I started with the price of risk in markets (equity risk premiums and default spreads) and then about relative risk measures. In this last section, I will bring together the return measures discussed in the last section with the hurdle rates estimated in prior posts to create composite measures of excess returns, as measures of value creation.

Excess Returns Definitions and Usage
While businesses that make money are viewed as successful, that is a low hurdle for success. After all, capital is invested in businesses and that capital invested elsewhere, in equivalent risk investments, could have earned a return. That return is what we were trying to estimate, with all of its complications, in my previous updates on risk free rates, equity risk premiums and relative risk measures.

These comparisons, which are at first sight simple, are complicated by how well we can measure how much capital is invested in a project or existing assets and how closely the accounting earnings capture true earnings. Adding to the measurement issues is the fact that earnings are volatile and using a single year's number can skew our conclusions.

Excess Returns: A Global Overview
With the caveat in mind that the returns on capital that I compute for individual companies reflects operating income in 2019, a potential problem given that it is just one year and a number that clearly will change (and fairly dramatically so) because of the virus, I compared the return on capital to the cost of capital for each of the 39,000 non-financial service companies in my sample and used that comparison to create a global distribution of excess returns: 

The story here is a depressing one, at least for this comparison, as 54% of global companies generated returns on capital that were lower than their costs of capital by 2% or more, and 32% of global companies earned returns that exceeded their costs of capital by 2% or more; 14% of companies earned returns that were within 2% of their costs of capital. The only part of the world where more companies earned more than their cost of capital than earned less was Japan, and even there, there are questions about whether this is an artifact of Japanese accounting practices rather than a sign of value creation. To complete the assessment, I looked at excess returns generated, by industry, and created a listing of the five industry groups with the most positive and the five with most negative median excess returns:
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You may be surprised to see biotechnology and healthcare IT at the top of the list of negative excess return businesses, but given that many of the companies in these industries are still  young, money-losing firms with promising products in the pipeline, this may be more a reflection of the limitations of using return on capital with young companies, than a true measure of excess returns. The presence of mining and oil/gas on the list is more troubling, since it suggests that even before the brutal shocks meted out in markets in the last few weeks, these sectors were struggling. It should be no surprise that the businesses that have the highest excess returns are mostly service companies, with low capital intensity, with the exception of tobacco, a high-margin business that also has the benefit of providing a non-discretionary product.

Wrapping up
Heading into a post-virus economy, where there will be wrenching changes in most sectors, you may wonder why I even bother looking at the profitability and excess returns from 2019. After all, every one of the numbers reported in this post will be dated, as companies update their financials to reflect the damage done. That said, I think it still makes sense to look at growth, profitability and reinvesting, pre-crisis, to get a sense of how much punishment companies can take. In businesses that already had anemic revenue growth, low margins and poor investment efficiency, the effects of the crisis will be far more devastating than in businesses with higher growth, margins and efficient investment. There is a reason why airlines, retail and oil are in the front lines of this war, suffering the most casualties, and why technology and heath care are doing better.

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1. Growth, Profit Margins, Reinvestment Efficiency and Excess Returns, by Region: 2020
2. Growth, Profit Margins, Reinvestment Efficiency and Excess Returns, by Industry: 2020