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## On credit & debt & debt & credit (& zombies) ##

February 25, 2018 by James Whelan

“James, come on. This all seems a little bit soft. You haven’t actually given a reason or time for another correction. All you’ve said is that there might be a bigger one at some point.”

The relatively young and still in fairly good shape for his age investment manager was ready for this thrust and, through the crackly line from Sydney to Hong Kong, immediately reverted to the Primary Directive of Investing as his parry.

“Guys, listen. The first and foremost priority of every advisor and every investor at any level of this industry is capital preservation and the management of risk. That’s what I’m getting at. We’ve had a warning shot fired across the bow and so much of the market was caught without any cash to buy the dip.
The market will probably reach new highs and we’re all about it doing so. All we’re urging is speed and vigilance. The next correction will be faster and bigger than the last because the market won’t let it happen again. The rush to cash will be fast & furious. I can’t tell you what causes the next correction. For now it’s not 10 Year Treasury yields. For now.”

James ended the sentence in a manner indicating his point was over. The delay in sound from Sydney to Hong Kong and then broadcast to the world meant a clear ending to answers was a required courtesy. A continuation of the answer after a long pause might collide with the next question and cause an embarrassing “no you first….no you first” back and forth and with the limited time available that wasn’t helpful.
In fact, James had a more direct answer to the question. It had been bubbling away in the back of his mind all morning but he wasn’t in the right mood or capacity to share it. A live interview with Bloomberg Radio at 12pm on a Friday following a very long week was never going to get the best out of James but he enjoyed the chance to keep his mind sharp and try to make a few points where possible.

The words “credit, debt, credit & debt” continued to beat at the back of his skull at an ever increasing ferocity.
That was the answer. But how to convey such a topic? He ended the interview and did his best to figure out what it all meant and how it mattered.

**OK, end of third person, into the first person. Apologies.**

We’ll take this short break to note that Berkshire Hathaway is 82% cash. Just think about that as you read on.

I couldn’t really find the right summary of how credit/debt impacts markets until this weekend reading the Financial Times.
To begin, here’s the playing field as I see it:
– companies have been doing great with cheap money to borrow & grow and/or buy back their stock and/or pay dividends
– cheap money is pretty much a thing of the past
– economic growth is still a thing
– economic growth brings inflation
– economic growth & inflation brings (loosely) wage growth
– companies have debt and shareholders greedy for similar returns to the last 9 years
– companies have Chiefs keen to please shareholders and continue the good times as long as possible.

Until an article in the FT by Alex Scaggs’ “On Wall Street” that outlined some research done by Morgan Stanley into US companies’ respective responses to the US corporate tax cuts.
It was easily put: how will US companies spend their 800bn USD windfall?
The stats: 400 recent earnings calls analysed, 28% of companies will return cash to shareholders (i.e. dividends & buybacks), 44% will lift capital expenditure. This is great. Loosely put & all things being equal, capex is good for economies, “returning cash to shareholders” is good for share prices.
With the above company numbers in mind, the Morgan Stanley white coats put it into real dollars: 43% of the tax savings will be spent on “cash return” and 30% on capex & wage growth.
That’s an interesting swing. More companies will put the tax savings into capex but the dollar figure will actually be higher for dividends & buybacks. 
OK, that’s interesting but here’s the really good bit. Only six per cent of companies are using this tax break to pay down debt.

Six. Per. Cent

Remember we’re in a rate rise environment in the States and debt is bad in that scenario. Pay it down when you can.
Ms Scaggs goes on to point to a Stanford University paper arguing what we already know is fact: shareholders are irrational beings.
Shareholders resist leverage reduction regardless of value add.
Shareholders prefer asset sales & equity issue to ease debt stress.
And, when cash flow increases, shareholders favour more borrowing, not less.

So shareholders (and obviously I understand I am one and represent many) are exactly how you think they are.
Squeeze what you can from a company and kick the debt problem down the road. The good thing about being a shareholder is that one day you are the partial owner of a company, the next day you don’t have to be.
Kicking the can down the road is a great investment strategy provided you lack any form of moral compass and don’t think too hard about the planet you’re leaving behind.

When deciding what sort of legacy to leave future generations, try to keep in mind the next generation after mine is eating laundry detergent for YouTube likes. 

So here’s the script:
– Companies have debt
– Companies get a tax credit
– Shareholders don’t reward debt reduction
– Shareholders reward buybacks & dividends
Companies that do the “right thing” (pay down debt) will be punished but eventually come out on top
Companies that do the “wrong thing” (buy backs & special divs) will be rewarded but eventually debt will be a bigger issue.
In short, the market is damned either way.

Two things you must do now:
1. Have a look at the next chart for the union between credit and company pressure.

2. Then do yourself a favour & Google “zombie companies FT” to get the Financial Times’ latest headlines on what happens when companies just managing to survive by paying off interest get an increase in repayments.

Something to think about as rates continue to rise. 10 Year Treasuries head towards 3% (massive round number) and recent minutes from the Fed show that four rate rises this year is a real chance. A few basis points here, a few basis points there and eventually you’re looking at some real numbers, especially when you’re a company borrowing a few million.

I’ll leave you with that and also the thought that just popped into my head that as usual, in the midst of all this, capex gets left to the side. In my opinion companies should have to have a capex increase to receive a tax credit. Respondents who say that sounds like the government getting too involved in company business receive the response that the government is already taking an arbitrary number away from company earnings by force to decide how best to spend it. In for a penny, in for a pound.


We closed our long position in OzMinerals after their stellar report and also our Italian banks position pending the Italian election.
Europe is starting to find its way to the front of my mind as I try to sleep at night which means the old cycle is in play:
Euro rises, European companies (50% of listed companies’ revenue is derived offshore) start to suffer. Like the tides, this is.

BHP didn’t quite hit the high expectations expected of it and took a hit but has for the most part come back to a ~10% profit.

We still prefer global banks and (for now) commodities/diversified miners. We also prefer cash to buy the former in times of correction and have a close eye on the USD movements to decide the medium term fate of the latter.

All the best,


James Whelan & the VFS Global Macro Fund
Level 30 Australia Square, 264 George Street, Sydney NSW 2000
t +1300 220 360  | m +61 407 958 036 |



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James Whelan