Our Current Situation
The time we currently live in will be studied by economists for years to come. The Great Recession, the stimulus, bailouts, bankruptcies, TARP, QE, ZIRP and many other acronyms that I forgot. Soon, we will be entering another one of those periods that will occupy pages in a $1,500 textbook. The Fed has stated its intention to officially end QE in October of 2014, concluding five years of easing, and bringing the total amount of instruments purchased at around $4 trillion. Though the bond buying program is will be over, Chairwoman Yellen has stated that interest rates will not rise until at least 2015, which is nice, but how should companies be preparing for the future?
Businesses have taken advantage of the cheap money being offered to great affect. So much so in fact that they are sitting on over $1.5 trillion in cash, and that's after spending it on over $1.75 trillion worth of M&A, the highest level since 2007. The problem is that this activity is happening at the most expensive point possible. With the indexes breaking record after record, companies are buying their targets at the highest price possible, and then paying a premium. As mentioned before however this era is soon coming to an end, so what should businesses do now to avoid becoming deer in the headlights of the Fed?
They Must Play Ahead
I'm a hardcore golfer, and in golf one of the many cardinal sins is not playing ahead. The shot off the tee depends on the approach you want, the approach depends on what putt you want, and so on. To blast it off the tee and deal with the consequences is both unpredictable, and a sure-fire way to guarantee you will lose.
The Fed has provided a wide fairway for which companies to tee off, but it's almost time to hit the approach. We can laugh and brag about the drive (M&A) but the smart players are focused on a green that is heavily guarded (interest rates).
Debt is probably the measure I focus on the most when researching a company for investment. Debt can be used as a weapon to secure dominance, through acquisitions or investment, or as a drug that the company becomes addicted to and overdoses. When bubbles collapse, such as the tech bubble of 2000 or the railroad bubble of 1893, it's the debt laden companies that die, the ones that survive stay healthy. With that, lets look at the Dow 30 in this light:
|Ticker||Cash||Cash+Short Term Inv||Current Ratio||Total Debt|
*I cannot speak for any of the banks (and GE) because I'm convinced bank balance sheets are actually ancient wizard tomes that witches use to give orders to the Illuminati.
The cash is there, not doing anything for anybody. Nike could pay off it's debt today and have almost a billion dollars left over. Why they haven't yet is beyond me. Six companies on this list could cover their current cash with short term investments, and being as it is with the markets at all time highs, why wouldn't they shave some off?
|Ticker||Cash (Covered by Short Term Inv)||Debt Reduction|
Fourteen of the thirty could reduce they're debt load by 10% with less than have of their current cash. What could be a better use of their cash hoards than reducing interest rate risk? Buybacks at these times would simply be foolish, but debt reduction lowers the overall risk of the company.
I understand that I'm ignoring dividends that have yet to be paid, but that's why I included the example of short term investments covering the cash. I also understand that a ton of cash is being held overseas. The money overseas however is doing exactly what the money here is doing; sitting there. They should either expand, pay foreign debt, or move it here, to do anything else costs everyone time, which of course is money.
While they may not be making the massive lump sum payments I am suggesting, some companies are making progress on their debt. The chart below lists the change in debt from 2009-2013, when ZIRP began, and from 2013-2014, when it was common knowledge that interest rates would rise in 2015:
|Ticker||2009-2013||Dec 2013-July 2014|
As you can see almost everybody took great advantage of the cheap money, with Coke leading the way at a 200% increase in debt. When we found out when interest rates would be rising soon after 2013, they only seemed to slow down the growth of their debt, and only a few actually started decreasing it.
Interest rates can only come up from here, ZIRP cannot last forever. Companies must use the mountains of cash they've earned to pay down debt in preparation for the uncertainty ahead. Reducing interest expenses today improves a companies chances at being able to take advantage of a crisis tomorrow. So with this in mind I suggest only buying companies who are either debt free or are consistently paying down their debt.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.