(July 29): In the aftermath of the global financial crisis (GFC), central banks around the world embraced aggressive monetary policies to minimise the fallout and kick-start the recovery process. That includes cutting policy rates to historic lows, even into negative territory, as well as launching massive quantitative easing programmes.
A decade later, the world’s biggest central bankers are, once again, poised for a fresh round of monetary easing as global economic growth loses momentum.
By putting a cost on deposits, policymakers hope to push banks-investors further out on the risk spectrum and boost credit expansion. Substantially reducing the cost of borrowings would also encourage businesses to invest and expand.
And companies have taken advantage of this — in advanced countries and even more so in emerging economies. Statistics from the Bank of International Settlements showed that Chinese corporates, in particular, have been on a debt binge, with total borrowings rising more than fourfold in the past decade. Corporate debt-to-GDP stood at 152% at end-2018, up from 98% at end-2008 (see Chart 1).
Borrowings by US corporates too have risen since the GFC, albeit by a smaller quantum. Total borrowings rose 43%, while debt-to-GDP is up from 72.6% at end-2008 to 74.4% last year.
We see a similar rise in overall gearing for companies listed on the Singapore Exchange and, to a lesser extent, in Malaysia. Net gearing for the former more than doubled from 21.5% in 2010 to 43.4%, on average, while that for companies listed on Bursa Malaysia rose from 26.5% to 33% over the same period (see Chart 2).
The danger is that the flood of liquidity and historic low costs have allowed for even companies with weak balance sheets to increase their debt piles. Indeed, the Organisation for Economic Co-operation and Development noted that the share of lowest-rated investment grade bonds (BBB) has almost doubled to nearly 54% of the total outstanding, a historic high.
Yields on government bonds have fallen sharply. There are currently more than US$13 trillion ($17.8 trillion) worth of not just government bonds but also corporate debt that are yielding less than zero returns. The risk premium for corporate bonds has narrowed significantly. This month, Europe saw more than a dozen junk bonds (below investment grade) trading with negative yields.
All of the above suggests that investors may be under discounting risks in the chase for yields. How will this end and are we headed into another financial meltdown?
Tables 1 and 2 show select companies listed on Bursa and SGX that have poor interest coverage and cash flows from operations. We are not saying these companies are in financial trouble or bound for failure. Some may be taking advantage of cheap debt while rewarding shareholders with higher dividends and buybacks. These discretionary payouts can be reduced in case of financial distress.
Notably, borrowing to fund business expansions, investment in productive assets and value-accretive mergers and acquisitions is positive, as these would generate greater incomes down the road.
On the other hand, cheap money could also lull businesses into investments with too-low returns or allow bad companies to survive far longer than they should. These zombie companies are a waste of precious resources that would be better applied elsewhere in the economy.
Companies with high levels of borrowings and/or generate insufficient cash flow to cover interest expenses would be particularly vulnerable when the economy turns down or if inflation and interest rate start to rise, particularly if the debt needs to be refinanced.
It does appear that, by and large, listed Singapore companies have used their debt wisely. There are only 29 companies that met our cash-flow criteria, many of which are smaller-cap stocks. The list of Malaysian companies is longer, triple the number. This could be a reflection of what I wrote about some weeks back — Malaysian companies have generally not done as well over the past five years.
To quickly recap, total net profit for companies listed on the Bursa throughout 2014 to 2018 fell at a compounded rate of 6.8% a year while net profit margin contracted, from an average of 11.3% in 2014 to 7.7% in 2018. On the other hand, profits for Singapore companies showed an average compound annual growth rate of 2% over the same period. Average net margin trended higher, from an average of 7.1% in 2014 to 8.8% in 2018.
Given the prevailing low returns on bank deposits and bond yields, stocks present an attractive alternative. But one must evaluate the underlying fundamentals of each company.
We also did a back-of-the-envelope calculation comparing the price-to-earnings valuations of highly geared companies against those with net cash, within the same sector and with similar market caps, on average.
The results show that within the construction, consumer, property and industrial product sectors, the average PE valuations for highly geared companies are higher than those with net cash, while the reverse is true for the plantation sector. This is counter-intuitive, as one would expect companies with stronger balance sheets to be valued more.
There is nothing wrong with buying risky stocks, but do so with eyes wide open and do not under-discount the risks. I believe the equity market is currently underpricing risks, perhaps inevitably, given the current “liquidity stimulated” growth. This imbalance in returns and risks presents arbitrage opportunities. Next week, I will look at whether the bond market is also “underpricing” risks.
My Global Portfolio gained 0.5% for the week ended July 25. Shares in defence contractor Northrop Grumman surged after reporting better-than-expected earnings. Last week’s gains lifted total returns since inception to 11.4%. The portfolio is outperforming the benchmark index, which is up 8.8% over the same period.
Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports
