Monday, February 27, 2023

Data Update 6 for 2023: A Wake up call for the Indebted?

We have an uneasy relationship with debt, both in our personal and business lives. While it is a financial decision, it is one that is freighted with moral overtones, since almost every religion inveighs against debt's sins, labeling those who lend as sinners and those who borrow as weak. That may reflect the concern that once a person or entity starts borrowing to fund its needs, it is easy to overuse debt, and risk its wellbeing in the process. All that said, businesses around the world have borrowed money though time to fund their operations, sometimes for good reasons and sometimes for bad, and over time, these businesses have also faced cycles of too much debt leading to painful cleansing. In this post, I will focus on corporate debt in 2023, keeping in mind that it was a year where the tradeoffs changed, as interest rates rose to pre-2008 levels, and putting at risk those firms that had borrowed to capacity, or even beyond, at low interest rates.

Debt's place in business

    To understand debt's role in a business, I will start with a big picture perspective, where you break a business down into assets-in-place, i.e., the value of investments it has already made and growth assets, the value of investments you expect it to make in the future. To fund the business, you can either use borrowed money (debt) or owner's funds (equity), and while both are sources of capital, they represent different claims on the business. Debt provides contractual claims, in the form on interest payments and principal repayments, whereas equity is a residual claim, i.e., you receive whatever cash flows, if any, that are left over after other claim holders have been paid:

This breakdown should take out the mystery out of debt, since it converts it into a source of capital, and the question of whether you should borrow to fund a business, and if yes, how much you should borrow becomes one of choosing between a source of capital that gives rise to contractual claims, with all of its pluses and minuses, and one that gives rise to residual claims, with all of its benefits and costs. Note that this framework applies for all businesses, from the smallest, privately owned businesses, where debt takes the form of bank loans and even credit card borrowing and equity is owner savings, the largest publicly traded companies, where debt can be in the form of corporate bonds and equity is shares held by public market investors. Even government-owned businesses fall under its umbrella, with the key difference being that equity is provided by the taxpayers.

Good Reasons for Borrowing

    What are the pluses and minuses of borrowing, if you take a clear-eyed look at it just as a capital source? First, borrowing money cannot alter the operating risk in a business, which comes from the assets that it holds, either in-place or as growth investments, but it will affect the risk to equity investors in that business, by making their residual claim (earnings) more volatile, In addition, the contractual claim that comes with debt can create truncation risk, because failing to make interest or principal payments can result in bankruptcy, and effective loss of equity. Second, borrowing money at a lower rate, by itself, cannot alter your overall cost of funding, since that cost is determined by the risk of your assets. Hence, the benefits of borrowing at a lower rate will always be offset by a higher cost for equity investors, leaving the cost of funding unchanged, unless a finger is put on the scale, giving one source special benefits. In much of the world, governments have written tax codes that do exactly this, by making interest payments on debt tax-deductible, while requiring that cash flows to equity be made out of after-tax cash flows. That tax benefit of debt will increase with the marginal tax rate, making it much more beneficial to borrow in countries with high tax rates (Germany, Japan, US) over those with lower tax rates (Ireland, much of Eastern Europe). The chart below lists the tax benefits as the primary benefit of borrowing and the expected bankruptcy cost as the primary downside of debt:

There are also ancillary benefits and costs that the chart notes, with debt operating as a disciplinary tool in some businesses, when managers consider taking new projects, since bad projects can plunge the firm into bankruptcy (and cause managers to lose their jobs), and the challenge of managing the conflicting interests of equity investors and lenders, that manifest in covenants, restrictions, and legal costs.

Bad Reasons for Borrowing

    There are many bad reasons for borrowing, and some companies seem intent on using these bad reasons. The first, and the one offered by most debt-heavy entities is that using more debt will result in higher returns on equity, since there is less equity at play. That is technically true, for the most part, but since the cost of equity rises proportionately, that benefit is an illusion. The second is that debt is cheaper than equity, to which your response should be that this is true for every business, and the reason lies in the fact that lenders have first claim on the cash flows and equity investors are last in line, not in some inherent cheapness of debt. The chart below lists these illusory benefits:

On the other side of the ledger, there are some companies that refuse to borrow money for bad reasons as well. The first is that borrowing money will lower net income, as interest expenses get deducted from operating income, but that lower net income will be accompanied by less equity invested in the firm, often leading to higher earnings per share, albeit with higher volatility. The second is that borrowing money will increase perceived default risk, and if the company is rated, lower ratings, and that too is true, but borrowing money at a BBB rating, with the tax benefit incorporated, might still yield a lower cost of funding that staying at a AA rating, with no debt in use.

The "Right" Financing Mix

     Is there an optimal mix of debt and equity for a business? The answer is yes, though the payoff, in terms of value, from moving to that optimal may be so small that it is sometimes better to hold back from borrowing. In this section, I will lay out a mechanism for evaluating the effects of borrowing on the cost of funding a business, i.e., the cost of capital, and talk about why firms may under or overshoot this optimal.

An Optimizing Tool

   In my second and third data posts for this year, I chronicled the effects of rising interest rates and risk premiums on costs of equity and capital. In computing the latter, I used the current debt ratios for firms, but made no attempt to evaluate whether these mixes were "right" or not. That said, the cost of capital can be used as an optimizing tool in assessing the right mix of debt and equity, with the optimal mix being the one that yields the lowest cost of capital. That computation, though, is a dynamic one, since both the cost of equity and the cost of debt will change as a business changes its debt ratio:

In effect, you are trading off the benefits of replacing more expensive equity with lower-rate debt against the resulting higher costs of equity and debt, when you borrow more. As you can see, the net effect of raising the debt ratio on the cost of capital will depend on where a firm stands, relative to its optimal, with under levered firms seeing costs of capital decrease, as debt ratio increases, and over levered firms seeing the opposite effect. 

As to the variables that determine what that optimal debt ratio is for a firm, and why the optimal debt ratio can range from 0% for some firms to close to 90% for others, they are simple and intuitive:

  1. Marginal tax rate: If the primary benefit of borrowing is a tax benefit, the higher the marginal tax rate, the higher its optimal debt ratio. In fact, at a zero percent tax rate, the optimal debt ratio, if you define it as the mix that minimizes cost of capital is zero. The picture below captures differences in corporate marginal tax rates, entering 2023, across the world:
    Download marginal tax rates, by country

     As you can see from the heat map and table, most countries have converged around a tax rate of 25%, with a few outliers in Eastern Europe and parts of Middle East having marginal tax rates of 15% or lower, and a few outliers, including Australia, India and parts of Africa with marginal tax rates that exceed 30%. Of these countries, Australia does offer protection from double taxation for equity investors, effectively endowing equity with some tax benefits as well, and reducing the marginal tax benefits from adding debt.
  2. Cash generating capacity: Debt payments are serviced with operating cash flows, and the more operating cash flows that firms generate, as a percent of their market value, the more that they can afford to borrow. One simplistic proxy for this cash generating capacity is EBITDA as a percent of enterprise value (EV), with higher (lower) values indicating greater (lesser) cash flow generating capacity. In fact, that may explain why firms that trade at low EV to EBITDA multiples are more likely to become targets in leveraged buyouts (LBOs) or leveraged recapitalizations..
  3. Business risk: Not surprisingly, for any given level of cash flows and marginal tax rate, riskier firms will be capable of carrying less debt than safer firms. That risk can come from many sources, some related to the firm (young, evolving business model, highly discretionary products/services), some to the sector (cyclical, commodity) and some to the overall economy (unstable). The company-specific factors show up in the risk parameters that you use for the firm (beta, rating) and the macro and market-wide factors show up in the macro inputs (riskfree rates, equity risk premiums)

If you are interested in checking how this optimization works, download this spreadsheet, and try changing the inputs to see the effect on the optimal. I looked Adani Enterprises, the holding company for the Adani Group and estimated the cost of capital and estimated value at different debt ratios: 


In my assessment, Adani Enterprise carries too much debt, with actual debt of 413,443 million more than double its optimal debt of 185,309 million, and reducing its debt load will not just lower its risk of failure, but also lower its cost of capital. This company is part of a family group, where higher debt at one of the Adani companies may be offset by less debt at another. To deal with this cross subsidization, I aggregated numbers across all seven publicly traded Adani companies and estimated the optimal debt mix, relative to the combined enterprise values:

The Adani Group collectively carries about three times as much debt as it should, confirming that the group is over levered as well, but note that this is bad business practice, not a con. In fact, as you can see from the cost of capital graph, there is little, if any, benefit in terms of value added to Adani from using debt, and significant downside risk, unless the debt is being subsidized by someone (government, sloppy bankers, green bondholders).

    If you have taken a corporate finance class sometime in your past life are probably wondering how this approach reconciles with the Miller-Modigliani theorem, a key component of most corporate finance classes, which posits that there is no optimal debt ratio, and that the debt mix does not affect the value of a business. That theorem deserves the credit that it gets for setting up the framework that we use to assess debt today, but it also makes two key assumptions, with the first being that there are no taxes and the second being that there is no default. Removing debt's biggest benefit and cost from the equation effectively negates its effect on value. Changing your debt ratio, in the Miller-Modigliani world, will leave your cost of capital unchanged. In the real world, though, where both taxes and default exist, there is a "right" mix (albeit an approximate one) of debt and equity, and companies can borrow too much or too little.

Effect on value

    If you can see the mechanics of how changing debt ratio changes the cost of capital, but are unclear on how lowering the cost of capital changes the value of a business, the link is a simple one. The intrinsic value of a business is the present value of its expected free cash flows to the firm, computed after taxes but before debt payments, discounted back at its cost of capital:

As you borrow more, your free cash flows to the firm should remain unaffected, in most cases, since they are pre-debt cash flows, and a lower cost of capital will translate into a higher value, with one caveat. As you borrow more and the risk of failure/bankruptcy increases, there is the possibility that customers may stop buying your products, suppliers may demand cash and your employees may start abandoning ship, creating a death spiral, where operating income and cash flows are affected, in what is termed "indirect bankruptcy costs". In that case, the optimal debt ratio for a company is the one that maximizes value, not necessarily the one at which the cost of capital is minimized.

Do companies optimize financing mix?

        Do companies consider the trade off between tax benefits and bankruptcy costs when borrowing money? Furthermore, do they optimize they debt ratios to deliver the lowest hurdle rates. The answer may be yes for a few firms, but for many, debt policy is driven by factors that have little to do with value and more with softer factors:

  1. Inertia: In my view, at most companies the key determinant of debt policy, as it is of most other aspects of corporate finance, is inertia. In other words, companies continue the debt policies that they have used in the past, on the mistaken view that if it worked then, it should work now, ignoring changes in the business and in the macro economy. That, for instance, is the only way to explain why older telecom companies, which developed a practice of borrowing large amounts during their time as monopoly phone businesses, continue that practice, even as their business have evolved into intensely competitive, technology businesses. 
  2. Me-to-ism: The second and almost as powerful a force in determining debt policy is peer group behavior. Staying with the telecom firm theme, newer telecom companies entering the space feel the urge to borrow in large quantities, because other telecom companies borrow. It is for this reason that debt policy is far more likely to vary across industry groups than it is to vary within an industry group.
  3. Because lenders are willing to lend me money: There is a final perspective on debt that can lead companies to borrow money, even if that borrowing is inimical to their own well being, and it is that if lenders offer them the money, you cannot turn them away. In fact, it is the excuse that real estate developers use after every boom and bust cycle to explain away why they chose to borrow as much as they did. The "lenders made me do it" excuse for borrowing money is about as bad as the "the buffet lunch made me overeat" excuse used by dieters, and it just as futile, because ultimately, the damage is self inflicted.
  4. Control: In my post on the Adani Group, I noted that in their zeal for control, insiders, founders and families sometimes make dysfunctional choices, and one of those is on borrowing. A growing firm needs capital to fund its growth, and that capital has to come from equity issuances or new borrowing. When control becoming the dominant prerogative for those running the firm, they may choose to borrow money, even if it pushes up the cost of funding and increases truncation risk, rather than issue shares to the the public (and risk dilution their control of the firm). 
The bottom line is that since firms borrow based upon their own past histories and their peer group policies on borrowing, there will always be firms that have too much debt, given their capacity to borrow, just as there will be firms at the other end of the spectrum that refuse to borrow, even though they can, because they have never borrowed money or because they operate in industry groupings, where no one borrows.

Measuring Debt Loads

    With the long lead in on the trade off that animates the borrowing decision, let us talk about how to measure the debt load at a company. While the answer may seem obvious to you, it is not to me, and I will start by looking at debt scaled to capital, a measure of debt's place in the financing mix, and then look at debt scaled to cash flows or earnings, often a better measure of potential default risk.

Debt to Capital Ratios

    In the financial balance sheet that I used at the start of this post, I noted that there are two ways of raising capital to fund a business, debt, with its contractual claims on cash flows, or equity, with its residual claims. Following up, it does make sense to look at the proportions of each that a firm uses in funding and that can be measured by looking at debt, as a percent of capital in the firm. That said, there are (at least) four variants that you will see in practice, depending on the composition of total debt, and whether capital is obtained from an accounting balance sheet (book value) or a financial balance sheet (market value):

  1. Gross versus Net Debt: The gross debt is the total debt owed by a firm, long and short term, whereas the net debt is estimated by netting out cash and marketable securities from the total debt. While there is nothing inherently that makes one measure superior to the other, it is important to remember that gross debt can never be less than zero, but net debt can, for firms that have cash balances that exceed their debt.
  2. Book versus Market: The book debt ratio is built around using the accounting measure of equity, usually shareholder's equity, as the value of equity. The market debt ratio, in contrast, uses the market's estimate of the value of equity, i.e., its market capitalization, as the value of equity. While accountants, CFOs and bankers are fond of the book value measure, almost everything in corporate finance revolves around market value weights, including the debt to equity ratios we use to adjust betas and costs of equity and the debt to capital ratios used in computing the cost of capital.

There are sub-variants, within these four variants, with debates about whether to use only long-term debt or all debt and about whether lease debt should be treated as debt. My advice is that you consider all interest-bearing debt is debt, and that picking and choosing what to include is an exercise in futility. 

    I computed gross and net debt ratios for all publicly traded, non-financial service firms, at the start of 2023, relative to both book and market value, with the distribution of debt ratios at the start of 2023 below:

If you have been fed a steady diet of stories of rising indebtedness and profligate companies, you will be surprised by the results. The median debt ratio, defined both in book and market terms, for a global firm at the start of 2023 was between 10% and 20% of overall capital. It is true that there are differences across regions, as you can see in the table below, which computes the debt ratios based upon aggregated debt and equity across all firms and is thus closer to a weighted average. On a book debt ratio basis, the United States, as a region, has the highest debt ratio in the world, but on a market debt ratio basis, Latin America and Canada have the highest debt loads.
    The problem with using debt to capital ratios to make judgments on whether firms are carrying too much, or too little, debt is that, at the risk of stating the obvious, you cannot make interest payments or repay debt using capital, book or market. Put simply, you can have a firm with a high debt to capital ratio with low default risk, just as you can have a firm with low debt to capital with high default risk. It is one reason that a banking focus on total assets and market value, when lending to a firm, can lead to dysfunctional lending and troubled banks. To the retort from some bankers that you can liquidate the assets and recover your loans, I have two responses. First, assuming that book value is equal to liquidation value may let bankers sleep better at night, but it can be delusional in industries where they're no ready buyers for those assets. Second, even if liquidation is an option, a banker who relies on liquidating assets to collect on loans has already lost at the lending game, where the objective is to collect interest and principal on loans, while minimizing defaults and liquidations.

Debt to EBITDA, Interest Coverage Ratios

    If debt to capital is not a good measure for judging over or under leverage, what is? The answer lies in looking at a company's earnings and cash flow capacity, relative to its debt obligations. The interest coverage ratio is the first of two ratios that I will use to measure this capacity:

Interest Coverage Ratio = Earnings before interest and taxes/ Interest expenses

As a lender, higher interest coverage ratios indicate a bigger buffer and thus more safety, other things remaining equal, than lower interest coverage ratios. While the interest coverage ratio is a widely used proxy for default risk, and the one ratio that best explains differences in bond ratings for a firm, its limit is its focus on interest expenses, to the exclusion of debt principal payments that may be coming due. The second ratio remedies this problem by looking at debt as a multiple of EBITDA:

Debt to EBITDA = Total Debt/ EBITDA

The logic behind this measure is simple. The denominator is a measure of operating cash flows, prior to a whole host of cash outflows, but a firm that borrows too much relative to EBITDA is stretching its capacity to repay that debt. 

    I compute both ratios (interest coverage and Debt to EBITDA) for all publicly traded firms and the results are graphed below, with the important caveat that they move in opposing directions, when measuring safety, with safer firms having higher interest coverage rations and lower Debt to EBITDA multiples;

Not only do interest coverage ratios and debt to EBITDA multiples vary widely across firms, but they also vary across sectors. On a pure numbers-basis, utilities look like they are the most dangerous firms to lend to, with skintight interest coverage ratios (1.17, in the aggregate) and sky high total debt to EBITDA, but that can be misleading since many of these utilities are monopolies with predictable earnings streams and the capacity to pass interest costs down to their customers. At the other end of the spectrum, technology and energy companies look the safest on an interest coverage ratio basis, but with both groups, you worry about year-to-year volatility in earnings. 

    To get a closer look at difference across companies, I looked at the 94 industry groups that I break down companies into, and look at the most highly levered (with total debt to EBITDA as my primary sorting proxy, but reporting my other debt load measures) and least highly levered industry groups, looking at just US publicly traded companies:

Download all industry group data

Real estate and real estate-based business dominate he most levered industry groups, with utilities, auto and airports rounding out the list, reflecting their history as well as the willingness of bankers to lend on tangible assets. Technology and commodity industry groups proliferate on the least levered list, reflecting the higher uncertainty about future earnngs and banking unease with lending against intangibles. (at least with technology companies).

The Default Question

    The biggest downside of debt is that it increases exposure to default risk, and as the last part of this analysis, I will look at default rates over time, culminating in 2022, and then look ahead to the challenges that companies will face in 2023 and beyond.

Business Default: The what and the why

    In principle, any company that fails to meet a contractual commitment is in default, at least on that commitment, but there is wide gap between that act and legal default, where there is an official declaration of bankruptcy, and courts step in. Furthermore, there is a gap between legal default and liquidation, where the assets of a firm are liquidated to pay off creditors. There are many firms that default on contractual obligations, but find ways to evade declaring bankruptcy, and among firms that declare bankruptcy, a significant subset restructure and stay in operations. If there were not the case, there would probably be a handful of airlines still in operations since the rest would have been liquidated years or even decades ago. 
    No matter what definition of default you adhere to, it arises from a simple mathematical construct, which is that a firm does not have the cash flows to service its debt payments, but that can occur either because cash flows drop off or because debt payments soar. Default, as a consequence, can broadly be traced to four factors:

  1. Company-specific troubles: A deterioration in a company’s operating business, either because of competitive pressures or the company’s own mistakes, can cause operating cash flows to drop, putting a once-healthy company at risk of default. In some cases, the shock to the company’s earnings and cash flows can come from the loss of a lawsuit (giving rise to large new commitments), a regulatory fine or other unexpected cash outflow. 
  2. Sector-wide issues: If disruption is the word that has excited venture capitalists and investors across the world for much of this century, it comes with a dark side, which is that the disrupted businesses can find themselves with imploding business models (shrinking revenues and operating margins under stress). As a consequence, over time, these disrupted firms find themselves more and more exposed to default risk; Bed, Bath and Beyond has less debt outstanding now than they did a decade ago, but have gone from credit worthy to bankrupt over that period.
  3. Macroeconomic shocks/changes: Some businesses, especially in commodity and cyclical industry groups, have always been and will continue to be exposed to cycles that can cause operating earnings, even for the best run and most mature companies, to swing wildly from period to period. Oil companies, for instance, went from being money-losers (on an operating income basis) in 2020, when oil prices plunged, to among the biggest money-makers in the business world in 2022. Speaking of 2020, we all remember the COVID-driven shutting down of the global economy in the first half of the year and the havoc it wreaked on borrowers and lenders, as a consequence.
  4. Debt payment surges: There is a final reason for default, which a surge in debt payments arising from rising interest rates and the refinancing of existing debt at those higher rates. Put simply, a company with a billion dollars in debt outstanding, at a 2% interest rate, will see its interest payments double, if rates double to 4%, and the debt is refinanced. Historically, this has been more an issue in emerging markets, where businesses borrow short term and rates are volatile, than in developed markets, where a combination of longer-term debt and more stable interest rates has insulated businesses from the worst of this phenomenon. But as I noted in my data post on interest rates, the last year (2022) has been a most unusual one, in terms of interest rate moves, in developed markets.
While all companies are exposed in one way or another to all of these factors, borrowing more money (and increasing contractual commitments) will magnify the effects; a more levered oil company will be more exposed to default risk than a less levered oil company, holding all else constant.

Defaults – Historical

    In my lead in to this section, I noted that defaulting on a loan or contractual obligation does not always lead to business default or bankruptcy, and that many bankruptcies do not conclude in liquidations. That said, though, the three data series (loan delinquencies, business defaults and business liquidations) do move together, with spikes in one coinciding with spikes in the other, In the graph below, I look at bank loan delinquencs in the United States and default rates among speculative grade companies over time:
Sources: Loan Delinquencies from Federal Reserve Site (FRED) and Corporate Defaults from S&P
Note that the series go through cycles, with increases in delinquencies and defaults triggered by macroeconomic or market-wide factors. In the late 1990s, it was an economic recession that was the precipitating factor, but the last three increases in delinquencies have had their origins in other forces. The increase in delinquencies in the early part of the 2000s started with the dot-com bust and made worse by the 9/11 attack, and subsequent economic weakness. The 2008 market crisis had the most damaging and longest lasting effect on defaults, partly because it originated with banks, and partly because of the long term damage it did to housing prices and the economy. The 2020 increase in default rate was triggered by the COVID shutdown, but was not only milder, but also passed quickly, with large bailout packages from the government being the difference.
    Looking at 2022, the most striking aspect of the time series is that there is almost no discernible change in delinquencies or defaults in the year, with both remaining at the low rates that we have seen for much of the decade. It is true that in the last half of the year, there were signs of trouble, with an uptick in delinquencies and an increase in the number of corporate defaults. Since interest rates rose during the year, the absence of an effect on defaults may surprise you, but there are two considerations to keep in mind. The first is that rising interest rates usually have a lagged effect on defaults, since it is only as companies refinance that they face the higher costs. The second is that the US economy stayed strong through 2022, notwithstanding headwinds, and corporate earnings stayed resilient. 

Ratings Actions and The Year Ahead

    If defaults measure the inability of companies to meet their contractual obligations, the actions taken by ratings agencies to change the bond ratings of the companies that they rate can operate as a leading indicator of expected defaults in the future. Put simply, ratings agencies are more likely to downgrade companies, if they foresee a potential uptick in defaults, and upgrade them, if they expect defaults to decline. While the actual defaults in 2022 remained low, it is clear that ratings agencies were becoming more concerned about the future, as can be seen in the number of ratings downgrades in the later parts of 2022, relative to upgrades:

S&P Default and Distress, Feb 2023

Note again that the downgrades in 2022 are nowhere near the downgrades that you saw in 2008, during the banking crisis, and one reason was that rising interest payments notwithstanding, the economy stayed robust during the year.

    Looking ahead to 2023, ratings agencies are forecasting rising default rates, perhaps because they see an economic slowdown coming. As with my forecasts for the S&P 500 and interest rates, you see a familiar duo of macroeconomic forces driving default risk:

Not surprisingly, a combination of high inflation and a steep recession will create the most defaults, as the vice of lower earnings and higher interest rates will ensnare more firms. At the other end of the spectrum, a swift drop off in inflation with no recession will create the most benign environment for lenders, allowing default to remain low. 

A Wrap

    In both our personal and business lives, there are good reasons for borrowing money and bad ones. After all, the politicians who lecture businesses about borrowing too much are also the ones who write the tax code that tilts the playing field towards debt, and by bailing out businesses or individuals that get into trouble by borrowing too much, they reduce its dangers. That said, there is little evidence to back up the proposition that a decade of low interest rates has led companies collectively to borrow too much, but there are some that certainly have tested the limits of their borrowing capacity. For those firms, the coming year will be a test, as that debt gets rolled over or refinanced, and there are pathways back to financial sanity that they can take. 

YouTube Video


  1. Debt ratios, by industry groupings (US, Global)
  2. Delinquency rates on bank loans, by Quarter (US): 1985- 2022

Wednesday, February 15, 2023

Data Update 5 for 2023: The Earnings Test

As I have argued in all four of my posts, so far, about 2022, it was year when we saw a return to normalcy on many fronts, as treasury rates reverted back to pre-2008 levels, and risk capital discovered that risk has a downside. During the course of the year, investors also rediscovered that the essence of business is not growing revenues or adding users, but making profits from that growth. In this post, I will focus on trend lines in profitability at companies in 2022, with the intent of addressing multiple questions. The first is to see how the increase in inflation in 2021 and 2021 has played out in profitability for companies, since inflation can increase profits for some firms, and lower them for others. The second is on whether these profit effects vary across geographies and sectors, by estimating profitability measures across regions and industries. The third is to revisit the link between profitability and value at companies, since making money is a first step for any business to survive, but making enough money to create value in business is a much more stringent test for businesses, and one that many fail.

Profits: Levels and Trends

   The end game for any business, no matter how noble its mission and how much good its products and services do, is to make money, since without profits, the business will soon run out of capital and sink into oblivion. That said, if you own the business, you may decide to accept less profits in return for social good, as you pursue your business, but you may not get the same degrees of freedom, if you are a manager at a publicly traded company, since you will now be doing good, with other people's money. Even in these cases, where you constrain your profits for the greater good, you still cannot stay on an endless path of losses. That said, there is surprising confusion about what it means for a company to make money, with different measures of profit used by investors, analysts and companies to bolster their priors about companies. To set the stage, I will start by laying out the differences measure of earnings that reported on an income statement:

At the top of the profit ladder is gross income, the earnings left over after a company has covered the direct cost of producing whatever it sells. Netting out other operating expenses, not directly related to units sold but still an integral part of operating a business (like selling and G&A expenses) yields operating income. Subtracting out interest expenses, and adding interest income and income from non-operating assets results in taxable income or pre-tax profit, and after taxes, you have the proverbial bottom line, the net income
    Not surprising, there is many a cost between the gross and the net versions of earnings, and while there remain a few firms, especially young and start-up, with negative gross income, the likelihood of losses gets progressively greater as you move down the income statement. In the graph below, I look at all publicly traded firms, listed globally at the start of 2023, and at the percent of firms, within each sector, that have positive earnings using gross, pre-tax operating and net income:

Not surprisingly, while more than 85-90% of all firms report positive gross income, that number drops down to just about 60%, with net income. All of the sectors are subject to the same phenomenon, but there are outliers in both directions, with health care have the highest drop off in money makers, as you go from gross to net income, and real estate and utilities having the smallest.
    Finally, I look at the aggregated values across all companies on all three income measures, across all global companies, again broken down by sector:

Collectively, global companies reported $16.9 billion in gross profit in the last twelve months leading into 2023, but operating income drops off to $6.4 billion and need income is only $4.3 billion. With financial service firms, where gross and operating income are meaningless, we report only net income, and the sector remains the largest contributor to net income across companies.

Profit Margins

    While absolute profits are a useful measure of profitability,  you have to scale profits to a common scaling variable, to compare companies of different scale.  One common scaling measure is revenues, and that scaling, of course, yields profit margins. The graph below draws a distinction between a medley of margins that are in use:

In addition to scaling gross, operating and net profits to revenues, to get to gross, operating and net margins, I have also added two variants. One is to compute the taxes you would have paid on operating income, if it had been fully taxable, to get after-tax operating income and margin, and the other is to add back depreciation to operating income to get EBITDA and EBITDA margin.
    Starting with gross margins, and computing the number for all non-financial service firms, we report the distribution of gross margins across publicly traded companies at the start of 2023, again based upon gross income and sales in the most recent twelve months:

While the median gross margin across all publicly traded global firms is about 30%., there are variations across the globe, with Chinese companies reporting the lowest gross margins and Australian companies having the highest. Some of that variation can be attributed to different mixes of businesses in different regions, since unit economics will result in higher gross margins for technology companies and commodity companies, in years when commodity prices are high, and lower gross margins for heavy manufacturing and retail businesses. 
    To explore differences in profit margins across industry groups, I broke stocks down into 94 industry groups, and sorted industries, based upon operating margin, from highest to lowest. In the table below, I list the ten industry groups with the lowest margins in the twelve months leading into 2023 and the ten industry groups with the highest:

Download spreadsheet with margins for all industry groups

The money-losers include four industry group from the retail space, a business with a history of low operating margins, a young industry in online software, a couple of industries in long-term trouble in airlines and hotel/gaming. The money makers include a large number of energy groupings, reflecting oil prices being elevated through much of the reporting period (October 2021-September 2022), a few technology groupings (software and semiconductors) and a declining, but high-profit business in tobacco.

Accounting Returns

    While profit margins tell a part of the profitability story, a high margin, by itself, may be insufficient to make a judgment on whether a business is a good one, i.e,, a business that consistently generates returns that exceed the cost of funding it. It is to remedy this defect that analysts scale profits to invested capital, with equity and capital variants:

In the equity version, you divide net income by book equity to estimate a return on equity, a measure of what equity investors are generating on the capital they have invested in a company. In the firm version, you divide after-tax operating income, again acting like the entire operating income would have been taxable, by total invested capital, the sum of book equity and book debt, with cash netted out, to obtain return on capital. The latter has several different names (return on capital employed, return on invested capital) with some mild variants on calculation, but all sharing the same end game. Both accounting returns are computed based upon book value, not because we have suddenly developed trust in accounting, but because the objective is to estimate what investors have earned on what they originally invested in a company, rather than an updated or a marked-to market value. I know that ROIC has acquired a loyal, perhaps even fanatical, following among financial analysts, and there are a few like Michael Mauboussin who use it to extract valuable insights about business economics and value creation, but I find that many analysts who use the measure are unaware, or unwilling, to learn about the limits of accounting returns. I have a long and extremely boring paper on the fixes that you need to make to the computation, especially with older companies and companies where accounting is inconsistent in its classification of expenses.
    Notwithstanding its many limits, I do think there is value in knowing what return on invested capital a company is generating, and I do compute the return on invested capital for every publicly traded non-financial firm in the world, and the calculation details are below:

The distribution of resulting returns on capital for the 42,000 publicly traded, non-financial firms are shown below:

The after-tax returns on capital, at least in the aggregate, are unimpressive, with the median return on capital of a US (global) firm being 7.44% (5.19%). There are a significant number of outliers in both directions, with about 10% of all firms having returns on capital that exceed 50% and 10% of all firms delivering returns that are worse than -50%.

Excess Returns

    If your reaction to the median return on capital being 7.44% for US companies and 5.19% for global companies is that they are making money, you are right, but when you invest capital in risky businesses you need to not just make money, but make enough to cover what you could have earned on investments of equivalent risk. It was in attempting to estimate the latter that I computed the costs of equity in my second post and costs of capital in my third. In fact, comparing the accounting returns from the last section to the costs of equity and capital that we computed earlier allows us to compute excess returns to equity and the firm:

Put simply, value creation comes from delivering returns on equity and capital that are higher than the costs of equity and capital, and while you can take issue with using accounting returns from the most twelve months as a proxy for long term returns, the comparison is still a useful one to make:

As you can see in this table, almost 70% of all listed companies earned accounting returns that were lower than their costs of equity or capital. On a regional basis, US companies have the highest percent of companies that earn more than the cost of capital, but still falling short of 50%, and Canadian companies performed the worst, with more than 80% of companies delivering returns that were lower than the cost of capital.
    It is certainly true that while the typical company had trouble making its costs of equity or capital, there are industry groups that generate returns that significantly exceed their costs, just as there are industry groups that operate as drags on the market. I look at the ten industry groups with the most positive and the most negative excess returns in the table below:
Download spreadsheet with excess returns for all industry groups

The rankings are similar to those that we got with margins, but it is clearly an ESG advocate's nightmare, as the list of companies that deliver the most positive excess returns are a who's who of companies that would be classified as bad, with tobacco, oil and mining dominating the list. 

  If 2022 was a reminder to investors that the end game for every business is to not just generate profits, but to generate enough profits to cover its opportunity costs, i.e, the returns you can make on investments of equivalent risk, and that game became a lot more difficult to win  in 2022. As I noted in my second and third posts, a combination of rising risk free rates and surging risk premiums (equity risk premiums and default spreads) has conspired to push the cost of capital of both US and global companies more than any year in my recorded history (which goes back to 1960). A company generating a 7.44% return on capital (the median value at the start of 2023) in the US, would have comfortably cleared the 5.60% cost of capital that prevailed at the start of 2022, but not the 9.63% cost of capital at the start of 2023. There will be, and  has already been, investor remorse about investments taken a year or more ago, but hoping that the cost of capital will come back to 2021 levels is not the solution. While there is little that can be done about past mistakes, we can at least stop adding to those mistakes, and one place to start is by updating hurdle rates, as investors and businesses, to reflect the world we live in,  rather than some normalized past version of it.

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Data Links
  1. Profit Margins (US, Emerging Markets, Europe, Japan, Global)
  2. Excess Returns (USEmerging MarketsEuropeJapanGlobal)


Saturday, February 11, 2023

Data Update 4 for 2023: Country Risk - Measures and Implications

I describe myself as a dabbler, and it does get in the way of my best laid plans. A few weeks ago, I posted my first data update pulling together what I had learned from looking at the data in 2023, and promised many more on the topic. In the month since, I have added two more data updates, one on US equities and one on interest rates, but my attention was drawn away by other interesting stories. Thus, I took a detour to value Tesla, around the time of their most recent earnings report on January 26, and added a second post to respond to the pushback that I got. About a week and a half ago, just as I was getting ready to start on my fourth data update, I got distracted again, this time by a story of a short seller (Hindenburg) targeting one of India's most visible companies (Adani Group) and I don't regret it, because that story is a good lead in to talking about country risk, which is the topic of my fourth data update. Irrespective of whether you think Hindenburg's short selling thesis against the Adani Group has legs, it is undeniable that the fate and value of this family group's companies is intertwined with the India story. A strongly growing India needs massive investments in infrastructure to succeed, and the Adani Group seemed uniquely qualified because of its perceived capacity to deliver on its promises, as well as its political connections. 

Country Risk - The Ingredients

    At the outset of this discussion, it is worth emphasizing that there is risk in investing in every country in the world, with the differences being one of degree. Thus, you would be making a mistake, if you assume that this discussion only applies if you are investing in India, Brazil or Belarus, and that it does not, if your investments are in the United States, Germany or Australia. The developed/emerging market divide was created by practitioners as a convenience, and while it sometimes has consequential effects, as is the case when a company is reclassified as developed from emerging, or vice versa,  much of what I will say about how governments, legal systems and regulatory frameworks can affect corporate value applies to all countries.


    If you accept my premise that not only is it more risky to operate in some parts of the world than others, but also that risk varies across countries and time, the next question become one of deciding what determines the magnitude of country risk in a country. In my annual updates on country risk, I go through these determinants in detail, but the picture below summarizes the drivers of country risk:

It should come as no surprise that the determinants of country cut across all dimensions, with politics, exposure to violence, legal systems and corruption all determining country risk exposure. It is not required, but it is generally true, that countries that score poorly on one dimension tend to also score poorly on others, with countries that are most exposed to war and violence also having dysfunctional or nonfunctioning governments and courts.    

A Life Cycle Perspective

    When asked to explain differences in country risk around the world, it is unfortunately true that much of that categorization is lazy and overly broad, often centered  around geography, culture and race. Thus, Asian countries were viewed as incapable of reaching first-world status, until Singapore showed that this was not true, at least on the city-state level, and Japan established its falsehood, with explosive growth and prosperity in the 1970s and 1980s. The stigma of being a Latin American or African economy persists, but there are success stories in both continents. At the same time, there are others who argue that groups with shared cultural or racial identities are incapable of elevate their countries to developed status. That is nonsense, since individuals within these groups often become success stories in a different setting or economy, unencumbered by the systemic inadequacies of their own countries. I believe that any country is capable of being a "first world" country, if it works systematically at creating a system that is perceived to be fair, timely in delivering legal redress and blessed with a government that has the interests of its populace as its first priority. By the same token, a country that is viewed as "first world" can lose that status, if people start perceiving the system as unfair, legal systems filled with delay and waster and a government that becomes capricious in its actions, or worse.

    On the specific question of how much governments matter in determining country risk exposure, I am going to adapt a structure that I use to look at companies, the life cycle, and apply it to countries:
In my simplistic picture, you can see how as countries evolve through the life cycle, the influence of government and country narratives changes on investment success/failure:
  • Role of Governments: In younger economies, the influence of government is central, in both good and bad ways, since these economies are almost entirely dependent on growth, and a combination of good (bad) tax, licensing and regulatory policies by the government can an act as a growth accelerator (destroyer). As economies mature, the effect that governments have on companies will recede, at lease on overall growth, though tax policy can  still redistribute that wealth and influence business behavior. When countries decline, government attempts to stem or slow decline can make them relevant again, in good and bad ways.
  • Country versus Investment/Company Narrative: That structure explains why when investing in a company in some countries, you have to not only do due diligence on these countries, but also form a narrative for how these countries will evolve over time. After all, your investment in Dangote Cement, a cement company with a dominant position in Nigeria nd West Africa, will do much better if that part of the world does well and will be handicapped, perhaps even fatally, if there is political and economic upheaval. In contrast, your investment in Krupps is less likely to be affected much by your views on the German economy.
  • Uncertainty: When investing, uncertainty is part of the process, but when that investment is in a project or company in a young country, a significant portion of the uncertainty is about the country, rather than about the company or investment. Put simply, you are unlikely to find safe projects in risky countries, since country risk will undercut whatever perceived stability there is in the project's cash flows.
If your views on investing and valuation were formed by reading Ben Graham, and nurtured by listening to Warren Buffett, it is worth remembering the time and the setting for their sage advice. Put simply, the rostrum that when investing in a company, you should focus on the company's management and moats, and pay little or no heed to governments or macroeconomic indicators, may have worked for value investors in the United States, in the 1980s, but will not hold up not just in other parts of the world, but even in the United States in the 2020s. Globalization and the emergence of a world economy that is no longer centered on the United States has made it an imperative for all investors to think about and understand country risk. 

Country Risk: The Measures

    If investors have no choice but to deal with country risk frontally, in most parts of the world,  it follows that we have to come up with measures of country risk that can be incorporated into investment decisions. In this section, I will begin measures of country default risk, including sovereign ratings and CDS spreads, before moving to more expansive measures of country risk before concluding with measures of equity risk premiums for countries, a pre-requisite for estimating the values of companies with operations in those countries. 

Default Risk

   As with individuals and businesses, governments (sovereigns) borrow money and sometimes struggle to pay them back, leading to to the specter of sovereign default. Through time, these defaults have led to  consequences that range from mildly negative to catastrophic, with some defaults triggering invasions and political revolutions. It is also the aspect of country risk, where there is the longest history of measurement, and there are widely used measurement tools.

1. History of Sovereign Default

    In 2022, there were five sovereign defaults, with three (Russia, Belarus and Ukraine) a direct consequence of Russia's invasion of Ukraine, and Sri Lanka and Ghana joining the ranks, for different reasons. Those sovereign defaults are the latest in a long list of defaults that stretches back into the nineteenth century, and the graph below shows defaults in the most recent few decades, across geographies:

Source paper

For much of the documented history, Latin America has been the epicenter for sovereign defaults, though there has been an upswing in Africa in recent years. Looking at the defaults over time, it is also worth noting that local currency defaults (where a sovereign defaults on a bond denominated in the local currency) have comprised a sizable portion of defaults over time, as can be seen in the graph below:

Source paper

What does this all mean? The conventional practice, when estimating risk free rates, has been to use the government bond rate in the local currency, if available, as the riskfree rate in that currency, and that practice is wrong when markets perceive default risk in the sovereign and build that into the government bond rate. It is for this reason that I net out default spreads, based upon local currency ratings, from government bond rates to estimate riskfree rates  in multiple currencies at the start of 2023:

Download data

The differences in riskfree rates across currencies can be attributed to differences in expected inflation, which is at the heart of why a valuation that is consistent in its treatment of that inflation will be currency invariant. (Valuing a company in Turkish Lira should give you the same value as valuing the same company in Euros, differences in riskfree rates notwithstanding.)

2. Sovereign Ratings

    The ratings agencies that rate corporate default with ratings have also had a long history of assessing sovereign default risk, with sovereign ratings, with the numbers of rated countries increasing dramatically over time, with the number of countries rated by Moody's (S&) increasing from 33 (35) in 1990 to 152 (131) at the start of 2023.  Sovereign ratings, like corporate ratings, range from Aaa (AAA) in Moody's (S&P's) scale, to D (in default, with a couple of differences in how you read the ratings:

  • While each company generally gets one rating, countries are usually assigned two ratings, one for local currency borrowings and one for foreign currency borrowings.
  • The fundamentals that feed corporate ratings come primarily from its financial disclosures, though qualitative factors play a role. Sovereign ratings start with quantitative measures of a country's economic standing, but there are far more non-financial forces that seem to come into play.
No matter what you think about sovereign ratings as a measure of default risk, they are the most freely accessible measures of country default risk. At the start of 2023, I summarize the sovereign ratings for countries in the heat map below:

The red and orange part of the worlds have the highest default risk, at least according to Moody's, and you can see it covers large swaths of Latin America, Africa and Eurasia.
    While sovereign rating agencies have been accused of bias, with a skew towards giving lower ratings to emerging market countries, while over rating developed market countries, I believe that their real sin is that they are late in reacting to changes in default risk.  The last year (2022) was one that saw more bad news than good news on the ratings front, with Fitch downgrading 21 countries and S&P downgrading 16 countries (while posting a negative outlook, a pre-cursor to a ratings downgrade for 8 countries).

3. Sovereign CDS spreads

    The sovereign CDS market, a relatively recent entrant into the sovereign default risk game, has for the last two decades offered investors a market where they can buy insurance against default risk by sovereigns, and by doing so, provided a constantly updated, albeit noisy, measure of the default spreads of countries. In January 2023, there were 76 countries with sovereign CDS spreads available on the market, and they are listed below:

During 2022,  there was a suspension on trading on sovereign Russian and Ukrainian CDS, leaving us at the tender mercies of just the ratings agencies, It is worth noting that despite the abuse that ratings agencies get for ineptitude and bias, there is a signifiant overlap between their assessments and the market's assessments of country risk.

Overall Risk

    While default risk  measures are widely available and used, they can be rightly challenged as taking too narrow a view of risk. After all, there are countries that score low on the default risk dimension but are exposed to political and economic risks that are considerable, as is the case with much of the oil-rich countries of the Middle East. There are no easy remedies for this problem, but there are services that generate country risk scores that bring in multiple measures of risk. While the Economist, the World Bank and private services provide country risk scores, I will stay with Political Risk Services, a data service I have used for a long time, more because of my familiarity with it than for any perceived superiority in how it measures risk. The PRS reports risk scores for different dimensions of country risk, and a composite risk score, that includes all of them. The heat map below reports on PRS scores, by country, at the start of 2023:

Source: The PRS Group

More than in prior years, this year's PRS map reveals a divide between the default risk perspective on risk and the PRS perspective. For instance, India is viewed as marginally less risky than China, and both are viewed as riskier than Kazakhstan., and the United States is perceived as much riskier than Germany or the Scandinavian countries.

Equity Risk

    Having traveled the long and winding road from talking about the drivers of country risk to measuring country risk, we can take a shot at estimating the risk premiums we would use when investing in businesses, as equity investors, in these countries. Rather than bore with you the details of my approach to estimating equity risk premiums, which are described in excruciating detail in my paper on equity risk premiums (linked below), I will summarize how I estimated the equity risk premiums for countries at the start of 2023:

I start with the implied equity risk premium for the S&P 500 of 5.94% (see my second data update for 2023 for details) as my premium for mature market, and build up to the premiums for other markets from that, using default spreads as my starting point, and scaling them for the additional risk of equities. The resulting equity risk premiums, by country, are shown in the picture below:

With all of the caveats about country ratings and default spreads, the map still provides consistent estimates of equity risk premiums around the world. In fact, there are about a dozen countries that are unrated, where I have used their PRS scores to make estimates of their equity risk premiums.

Company Risk Exposure to Country Risk

   As a final piece of this post, I want to contest what seems to be the default assumption in much of valuation, which is that the risk of a company comes from where it is incorporated and traded, rather than where it does business. Effectively, it is what leads analysts to value US companies using the US equity risk premium and Indian companies with the Indian equity risk premium, even though both groups of companies may make their products in and derive their revenues from other parts of the world. I believe that a company's exposure to country risk should be based upon where it operates, though we can debate how best to measure this country exposure, with revenues, production or a mix of the two in play, for weighting. 

I know that there are risks that derive from where a company is incorporated, and that its regulatory and tax structure may be affected by that choice, but to argue that this is the dominant risk at play does not stand up to common sense.
    The implications for investment and valuation are simple. Investors and analysts who paint country risk with a broad brush, using country of incorporation to measure equity risk premiums, will over value developed market companies like Coca Cola, Apple and Netflix, with significant operating exposure in emerging markets and under value companies like Infosys (India), Embraer (Brazil) and Vinamilk (Vietnam) by assigning the domestic equity risk premium to them, even though they generate large portions of revenues from foreign, and often much safer, markets. 

The End Game for Governments

    I know that I am going against the current political trend, but I believe that the end game for a good government is analogous to that of a good founder, and that is, once it has provided the structure and the basis for economic growth and prosperity, it should make itself less central to the economy, not more so. Note that while this may seem like the libertarian position, there are significant differences.  I do believe that it is a government's role to craft laws and regulations that minimize the externalities that businesses create, but those laws/regulations should be few in number and changes, when they happen, should be reasoned and infrequent and enforcement should be fair and timely. There is nothing more unsettling than being a business person, consumer or citizen in a setting, where you are faced an avalanche of rules, sometimes contradictory, that are constantly changing, and enforced inconsistently.

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