Debt has been a performance enhancing drug for many companies the past several years. Faced with a sluggish economy, CEOs have taken advantage of low interest rates and a favorable fixed income market to raise cash for acquisitions and share buybacks.
For disciplined investors looking to own businesses that can improve results organically without leveraging balance sheets, the “juicing” trend has been particularly frustrating.
Consider the deterioration in balance sheets during the current bull run. Total debt ratios have remained relatively stable but the use of long-term borrowing has grown. Between March 2009 and the end of 2016, the average long-term debt-to-capital ratio for companies in the Russell 3000® Index has jumped by a third from 33.7% to 44.6%. Abnormally low rates have delayed the sting of borrowing costs, but we believe the era of cheap money is winding down. As costs to service debt rise, the widespread surge in borrowing could be a stumbling block for many businesses.
We understand the temptation for management to use debt in a sluggish economy but also know history hasn’t been forgiving. As the chart shows, borrowing has spiked and a rise in defaults could follow. As a result, we think in the quarters ahead businesses that have been running with clean balance sheets will regain the advantage.