Value Investing When Debt Levels Are High

Includes: SPY
by: David Merkel, CFA

I would ask yourself how to implement value investing in an era where debt is no longer expanding. Arguably an era where inflation is increasing (albeit from a low starting point).

A few years ago, everyone “knew” housing prices never went down nation wide. Today, CNBC constantly tells us that the consumer is 70% of the economy… undoubtedly true when debt levels were expanding. But consumer income is not growing as fast as the cost of living, and debt levels cannot expand again. The “consumer is 70% of the economy” assumption probably won’t hold over the next few decades like it did in the past few decades. How does one implement value investing in such an environment?

So asked one reader in response to last night’s post. His full comment was similar to some of the musings of Bill Gross, in that we don’t live long enough to really prove we have skill in investing, but over the last 40 years the overall macroeconomic regime of expanding debt favored certain classes of investors.

A few thoughts:

1) Value investing is SAFE and cheap, not CHEAP and safe. Focus on margin of safety. Spend time asking what can go wrong. Test the strength of moats.

2) In 2008-2009, there were a lot of value investors that got savaged. Why? They invested a lot in statistically cheap financial companies that were carrying a lot of credit risk. Having worked for a hedge fund 2003-2007 that did the opposite, my own investing was constrained because I feared what might happen when the bear part of the credit cycle emerged (leaving aside a mortgage REIT that I foolishly held onto).

Credit-sensitive financials are like cyclical non-financials that have over-invested in productive capacity. They have high operating leverage, and will only prosper when demand is strong/credit is good. Cyclical companies often have low P/E multiples near the top of the cycle, because the bear phase is anticipated. They have high or negative P/E multiples near the bottom of the cycle, because the bull phase is anticipated.

The main idea here is to be skeptical of companies carrying a lot of credit risk, particularly after they have succeeded for some time. When the credit risk manifests, it is savage.

3) Avoid debt and products that require it. My portfolios ordinarily avoid companies with a lot of debt. I like companies that finance themselves internally through retained earnings. During bear market phases, companies with financial flexibility do better. It is always better to get financing at a time when you don’t have to get it. Seeking liquidity when little is available is never an attractive place to be.

Also remember that big ticket items like houses, cars, boats, RVs, college educations, do badly when credit conditions tighten. Luxuries are disadvantaged versus necessities also. Before the bear part of the credit cycle hits, own companies that are self-financing, and have stable revenues.

4) Inflation tends to favor value investing based on flow (income statement, cash flow statement) versus stock (balance sheet). In one sense, corporate pricing power boosts the value of companies that can pass on the inflation and then some. This was true in the ’70s when value investor did relatively well.

In summary, I would say that in the future, value investors need to focus on:

  • Safety first
  • Avoidance of credit risk, implicit and explicit
  • Investing in companies that don’t have to seek external finance
  • Companies that can pass on the effects of inflation.