The worst mistake I have made in recent years in economic forecasting was to expect the 2000 crash well before it happened. I started warning that a stock market recession was due in 1996 – I was still hung up on the 1989 to 1992 recession which had been more serious in London than in New York. Nevertheless, the recession did eventually come, though by 2000 the bears had mostly lost confidence and been converted into belated bulls.
I should never have tried to put a time to the downswing at the end of the boom, and I am not about to repeat that mistake. Nevertheless, there are a number of worrying developments which justify increasing caution. Most of them involve the risks of leverage.
Everyone knows that increasing the leverage is one way in which the financial performance of a stock can be improved without any improvement in the underlying commercial performance, and can be improved still more when the underlying performance itself is improved. Writing in the Financial Times, Roberto Mendoza, the Chairman of the Trinsum Group describes the process: “A more efficient capital structure (typically more debt); highly disciplined management (cost-cutting); strategic focus on core competencies (selling underperforming assets) and aligning management and owner incentives (pay, based on performance).
This is the mechanism by which private equity works. It is good for the shareholders because profits are higher and good for the management because bonuses, in some form or another, are also higher. It is not so good for the staff because jobs are lost. It is good for the economy in the short term, but may not be so good in the longer term. Private equity seldom takes a long term view – that is for someone else. This is not a win-win situation, because it can squeeze the interest of the workforce. In the United Kingdom, Brendan Barber, the General Secretary of the T.U.C., argues that “in companies that are often leveraged to the hilt, it’s employees who end up shouldering much of the risk, with downward processes on pay, pensions and job security.” There is also the problem of transparency. Private equity discloses much less than is required of public companies.
However, it is the leverage which worries me most, because over-leverage, or what proves to be over-leverage can create a lose-lose situation. The Congressional enquiries after the 1929 crash largely focused on the disaster of over-leverage in circumstances of recession. A company with low-leverage is sea-worthy in a storm. It is very unlikely to run out of cash, which is the problem which causes businesses to become insolvent. It will have assets which can be sold, or can be borrowed against.
The metaphor is that of the sailing ship. An over-leveraged company has a huge spread of sail, and can travel fast in favourable conditions; in a great storm she can keel over. A ship which carries light sail, does not win the race in favourable weather, but can survive a storm.
The assumption shareholders make when they increase the leverage is that there is not going to be an early recession, perhaps that there will be no recession at all. Early in a bull market, this assumption may be a safe one. Later in a bull market it becomes less safe, but investors feel more safe because they have become accustomed to good times. Finally the recession comes, probably at the time that the last bear has run for cover.
Now we have a fashion for high leverage – in derivatives, in private equity and in hedge funds. The global financial system has spread its sails. The momentum is awe-inspiring. There is less transparency than there used to be – investors do not understand derivatives; hedge funds are less transparent than old fashioned investment businesses; private equity is less transparent than public companies.
Any traditional value investor reads balance sheets with more confidence than he reads profit and loss accounts. The global P and L looks pretty good, but if the global balance sheet does not scare us – it certainly should.
for the Markets and Money Australia