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Expensive businesses + high debt = cause for concern

Expensive businesses with above-average debt are rarely the ingredients from which to make a successful long-term investment and yet that is just the combination that have been leading the US bull market

09/11/2018

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

At no point in the lifetime of any investor operating today has the US not been the largest stockmarket on the planet and yet it recently notched up a new kind of record.

According to numbers crunched by analyst Scott Irving of Jefferies International, at the end of Sdeptember, the US accounted for 62.4% of the developed world’s market capitalisation – an all-time high, based on data going back to the early 1970s.

Sure, we may have seen some wobbles in the last few weeks but clearly there cannot be any significant issues when one market dominates in this way … can there?

Well, as the multi-decade deflationary crisis in Japan attests, world-beating markets do not remain world-beating indefinitely – and while we are in no way suggesting the US will head the way of Japan, there are sound reasons to think its bull run is unsustainable.

The end of the bull run? 

Take, for example, some further analysis from Irving on the valuations of companies in the main US market, the S&P 500.

Here, he focuses on a business’s enterprise value (the entire value of a firm equal to its equity value, plus net debt, plus any minority interest) versus its sales numbers and, specifically, those trading at 5x or more of their sales at key points over the last 20 years.

At the market’s 2000 peak, for example, there were 50 such businesses while, at the 2007 high, this figure had actually more than doubled to 115. At the market’s 2009 trough, the number had fallen back to 23 but last month it was exactly 100 higher.

After the recent market falls, this number has reduced a little but is still around the 100-mark – and, remember, as these ratios consider a business’s enterprise value versus its sales, they are inherently inflation-adjusted and therefore like-for-like comparisons across time.

Again, this is not to say the US is heading for trouble or that equity markets are in for a torrid time – only that history would suggest we should be more cautious than optimistic today.

 The numbers don't lie

At this point, those still feeling bullish about the outlook for the US have been known to argue its companies do not have much in the way of debt – and yet the numbers say otherwise.

Taking those same points in time, the median level of US businesses’ net debt to their EBITDA (earnings before interest, taxes, depreciation and amortisation) was 1.32x in 2000, a more manageable 0.69x in 2007 and 0.86x at the market trough of 2009.

In the decade since, however, US companies have been on a bit of a spree, buying back shares, paying out dividends and generally spending money they really did not have so that the median level of leverage had reached 1.55x net debt to EBITDA at the end of last month.

Once again, that has ticked back slightly in recent weeks to a bit closer to 1.5x – but still clearly well ahead of where it was at the previous two market highs.

A tough case to make a successful investment 

For the record – and the sake of an element of simplicity – these ratios exclude the debt of utilities and financial companies but the point still holds that any significant collapse in markets, such as we saw in 2000 and 2007, would be very bad news indeed.

Still, one might at least hope that the most expensive US businesses would not have so much debt because then that really would be a concern …

And yet it turns out, at last month’s market peak, those companies whose enterprise value to sales ratio was 5x or more actually had a net debt to EBITDA ratio that was higher than the wider market – at 1.57x.

In other words, the most expensive businesses are also more leveraged than average and, to put it mildly, that is a tough combination from which to make a successful investment.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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