Shani Jayamanne: Welcome to another episode of investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs. 

Mark LaMonica: So today Shani we’re going to do a market update and we’ll obviously get to that in one second, but you have an important financial update.

Jayamanne: I do yeah, I bought a house.

LaMonica: Yeah, that’s exciting.

Jayamanne: It is yeah. I think we’ve spoken about this before in a couple of episodes about housing, but I had an IPS very similar to what I do for equities in my portfolio and I had a checklist for things I was looking for and I thought, too hard basket doing it myself so got a buyer’s agent and they found something that ticked every box.

LaMonica: Well, there we go. And I’ve been told – I saw a video of the house, a video walkthrough of it. I’ve been told that I need to come over and carry a bunch of bricks.

Jayamanne: Yeah, the backyard needs doing so.

LaMonica: Out of your backyard.

Jayamanne: Yep, that can be your housewarming present.

LaMonica: Yes, so you’re going to take the old man and make him carry bricks.

Jayamanne: Yes

LaMonica: Okay well we can keep updated on that, but we need to do a market update.

Jayamanne: We do need to do market update and they’re normally very popular episodes. 

LaMonica: Yeah no, they are very popular, and this is a little different because we generally do them when something exciting is happening in markets. And it is pretty safe to say that nothing exciting is happening at all. 

Jayamanne: But always good to do a bit of a check in. 

LaMonica: Yeah, not exactly, so we are a little more than 4 months into the year at least when we publish it – we are doing this on April 27, so everyone knows. So how about a quick recap in what has happened in markets? 

Jayamanne: Well let’s start locally. The ASX 200 is up a little more than 5%.  The S&P 500 is up just over 6%.  

LaMonica: Yeah, and a lot of those gains were early in the year and now it feels like we are in a bit of a holding pattern. And I think what is interesting is last year the market was all about interest rates. And the market was obsessed with any indication of how high they would go and when they would stop rising.  

Jayamanne: And we seem to have gotten to a point where at the very least they are starting to slow. The RBA left rates unchanged at their meeting in early April and the Fed is widely expected to raise by a quarter point in early May with many economists believing that is the last rate rise for the rest of 2023. 

LaMonica: And as I said earlier changing opinions about what was happening with interest rates and inflation were a huge driver of what has been happening in the market. And that makes sense because the market is forward looking. The volatility we see in the market is anticipation about what may happen in the future. And those expectations change which is why the market bounces around so much. 

Jayamanne: But we need to appreciate the fact that the impact of higher interest rates may just be starting. It takes a while for interest rate changes to be felt. Nobody knows for certain but estimates from economists range from 12 to 18 months. March 16th, 2022 was when the Fed in the US started raising rates. The RBA started raising rates in May of 2022. 

LaMonica: So, we are just hitting the low end of the estimate of when the rates are starting to take effect. And while the market has been anticipated the impact of the rate rises the question now is what actually happens. In the Silicon Valley bank episode and some of the issues around US and European banks we saw one of impact of higher rates. 

Jayamanne: And here in Australia there has been a lot of talk about the upcoming mortgage cliff. $350 billion, or more than half the fixed rate mortgages are due to expire in 2023. Another 38% of the loans will expire in 2024. The RBA estimates 90 per cent of the fixed rate loans rolling off this year or next year will have to wear mortgage repayment increases of at least 30 per cent. 

LaMonica: And this is reflective of a far larger global problem. The low interest rate era caused an unprecedented debt binge. People, companies, governments. Everyone. And like most of my binges this one is likely to end poorly as well. 

Jayamanne: Lets summarise the scale of the problem. According to Standard and Poor’s global debt has hit $300 trillion which is 349% of global GDP.  

LaMonica: And that is $37,500 US for every person on earth. And GDP per capita is just $12,000. 

Jayamanne: And we can use the debt to GDP ratio to show how profound the growth in debt has been. Let’s start with governments. Government debt grew between 2007 and 2022 by 76% and is now 102% of GDP. 

LaMonica: I guess it turns out all those covid programs and GFC programs weren’t free. If we turn our attention to the corporate sector the ratio is up 31% to 98% of GDP. And if we dig into those numbers, we can see a couple problem areas. 

Jayamanne: Chinese companies are one of the areas of concern. S&P looked at 6,000 Chinese corporations and found the average debt to earnings ratio was 6 times. That is twice the global average. 

LaMonica: And if we look at US companies the percentage of companies with junk status which is a credit rating of B- and below doubled and is now 36% of all companies.  

Jayamanne: Consumers actually are doing relatively well in comparison. Household leverage only increased 7% between 2007 and 2022 and comes in at 64% of GDP.  

LaMonica: I guess that counts as good news. In a higher interest rate environment this pile of debt we collectively amassed becomes more difficult to service. S&P estimates that 35% of debt is floating rate which means based on the interest rate raises in 2022 there were $3 trillion dollars in extra interest rate expenses. 

Jayamanne: And those extra costs to service debt will have a direct impact on the economy. For companies the extra expense comes directly out of profits for shareholders. For consumers and governments, it means less spending flowing through the economy. 

LaMonica: And this problem will get worse as fixed rate debt matures and has to be replaced at higher interest rates. And I think we need to be honest that all these companies are not going to make it. 

Jayamanne: And obviously with each interest rise this situation gets worse. So, while we wait for the impacts to be felt we also wait to see how high interest rates will get in this tightening cycle. 

LaMonica: And that is of course where we turn our attention to inflation. It has come down. But hasn’t come down to the range that central banks want. In the US the latest reading came in at 5%.  In the EU the last reading was 8.5%. In Australia our last reading was 7%. But there are stubborn signs in the economy that inflation is not being brought under control.     

Jayamanne: And this is what investors are waiting on. What is it going to take to get inflation under control. When will interest rates stop rising and what are the implications to overall economic growth and to government, corporate and consumers who hold all this debt. 

LaMonica: It is safe to say there is a lot of economic uncertainty. And while returns this year have been remarkably resilient, under the surface there are some causes of concern. Let’s take the S&P 500 for example. The rally this year have been driven by a really narrow group of companies. The percentage of companies that are outperforming the index is the lowest percentage since 2005. 

Jayamanne: And valuation levels are still by no means cheap to account for all this uncertainty. We seem to just be muddling through. Waiting to see what unfolds with the economy, waiting to see what happens with the foreshadowed spring offensives in Ukraine, the fight over the debt ceiling in the US and waiting to see if tensions keep rising between China and the west. 

LaMonica: And these are all reasons that we can use as investors to go into our shell. Wait until things seem less uncertain to invest. But there are always reasons not to invest. There are rarely times when there are no storm clouds on the horizon.  

Jayamanne: And if you are feeling uneasy about this situation then it might be a good time to just go back and revisit your plan. It will bring you peace of mind to know that you have a plan and strategy. But it also might be a good time to think a little bit about these larger macroeconomic forces that are occurring and how that might impact your portfolio. 

LaMonica: We’ve talked a lot about inflation and how finding companies that can show resilience by passing along increased costs of goods and services to their customers. It might also be a good opportunity to look at debt levels of the companies that you may hold and thinking about the implications of the easy money era being over. 

Jayamanne: A company that is carrying too much debt could also be carrying a good amount of risk. Companies that require continual funding through both the debt and equity markets might have issues continuing to get funding. Companies that have high debt levels are likely going to face higher interest costs going forward.  

LaMonica: Lets run through a couple examples. We can start with a company that is likely in big trouble. That would be our old friend ZIP.  

Jayamanne: We took a very negative view on ZIP back when it was an investor darling. 

LaMonica: Yes, we did. And the chickens have come home to roost. Zip is struggling to become profitable. They are facing brutal competition from other BNPL companies and other players including Apple and the banks. And they are running out of cash. Now throughout their history they have just gone back to the well. When their share price was high, they raised more equity capital. And they kept borrowing and borrowing.  

Jayamanne: They had a billion dollars of debt at the end of 2020. 2.1 billion at the end of 2021 and close to 2.8 billion by the end of 2022. This compares to $78m in cash they had at the end of 2022. And the issue is that they lost $1 billion last year in net income. And while our analyst who covers ZIP predicts they will cut that loss this year and further next year they need more cash to get through those losses. 

LaMonica: In fact, our analyst believes they will have to go back to the equity markets to raise more capital to get through this period. He predicts a $500m equity cash raise in 2024. But the share price has fallen by 90% since 2021 and this equity raise will dilute existing shareholders by tripling the shares available on the market. 

Jayamanne: Not a good situation for ZIP and not a good situation for many of the other unprofitable companies that were investor darlings before last year. Let’s contrast that with a company that is in strong shape financially.  

LaMonica: Let’s look at Aristocrat which primarily makes pokie machines. A scan of their balance sheet shows the strength of the company’s financials. At the end of 2022 they had $3b in cash and only $2.79b in debt. 

Jayamanne: Plus, if we look at Mark’s favourite part of the financials the cash flow statement, we can see they had free cash flow of almost $1b in 2022 on top of a profit of close to the same. 

LaMonica: And this financial flexibility allows them to keep operating aggressively in a difficult environment. They invest 12% of their revenue in research and development which compares favourably to their two main rivals International Game Technology which invests 7% of sales in R&D and Scientific Games which invests 9%.  

Jayamanne: Aristocrat is also able to reward shareholders thanks to this financial strength by paying out around 40% of earnings to shareholders in the form of dividends. 

LaMonica: So, in an environment with so much uncertainty it is important to invest in companies that have the flexibility to respond to whatever happens with the economy. And one way you can do this is to look at our analyst ratings. Particularly the moat rating which indicates a sustainable competitive advantage which can help with the inflationary environment we are facing. Aristocrat has a narrow economic moat and ZIP has no moat. 

Jayamanne: But also, our uncertainty rating which measures business risk which is key in changing economic conditions and takes into account financial risk as well. Aristocrat has a medium risk and ZIP has an extreme risk. Finally, we have a capital allocation rating which assesses management’s track record of being good stewards of shareholder capital and the balance sheet. Aristocrat is exemplary and Zip is standard. 

LaMonica: And if you don’t have access to our ratings there are things you can look at as well. First you can take a look at the balance sheet. How much debt do they have and how much cash do they have. Take a look at their debt-to-equity ratings. That is an indication of their leverage and while they vary by industry you can compare two companies and compare a company to the industry average with lower being better. 

Jayamanne: You can also look at the companies’ credit rating. That will show what the credit rating agencies think of the company, and it will also have a direct impact on how much interest a company will have to pay to borrow money and their ability to issue debt in an uncertain market. Looking at the free cash flow is also valuable because of course the best thing is if they can internally fund their own spending without going out to raise more money. 

LaMonica: And if you really want to dig into a company look through their financial statements to see how much of their debt is fixed vs floating and when their debt is scheduled to mature. In a rising interest environment, we want fixed rate debt that is maturing far out into the future, so they don’t get that hit of higher interest rates for a while. 

Jayamanne: So, I think the question Mark is, if investors should make wide scale changes to their portfolios in light of the uncertainty. We already suggested that going to cash is not a good approach since there will always be uncertainty in the market and sticking your head in the sand isn’t a way to achieve your goals. What about rotating into companies that are in better financial and competitive positions? 

LaMonica: Well, this is a tricky one Shani. I’m not a big fan of constantly rotating your portfolio due to market conditions. This is not a good approach to achieving your goals. The uncertainty in the markets right now is not exactly a secret and by the time many people make these rotations we’ve already seen the market adjust. We saw that last year when unprofitable companies got hammered and large dividend paying profitable companies did relatively well.  

Jayamanne: Exactly. It is all well and good to sell ZIP now but as we said it is down 90%. Of course, we also suggested it wasn’t a great investment before that 90% decline. 

LaMonica: It is nice to get something right every once in a while. But rather than all this tinkering which causes tax and transaction costs it is perhaps a time to go back and think about what kind of companies you want to invest in. I’ve always been drawn to low business risk companies that are in strong financial position and have moats. So, my answer would be that is the way you should invest no matter what is happening in the market. 

Jayamanne: But the key is finding an investment approach that you are comfortable with and lowers the chance that you will constantly trade and tinker with your portfolio. Perhaps now is a time to reassess the types of companies you have in your portfolio. But we would urge you to write down the approach you want to take. The last thing we want you to do is to all of sudden revert back to a different investment approach after the market rallies and more speculative companies do well once the uncertainty comes down. A rally you are likely to have missed and will be too late for.  

LaMonica: That is after all a game for traders and as always, we encourage you to be an investor that holds for the long-term. 

Jayamanne: So, to summarise our market update we seem to be playing a bit of a waiting game right now. We don’t know where things will go from here anymore than you do or all the commentators who breathlessly pontificate on the next move by central banks and the next inflation reading. 

LaMonica: And remember to always zoom out. We’ve got a world that is awash in debt. Unwinding that debt is going to have implications. Servicing that debt in a higher rate world is going to have implications. So, watch your own levels of debt and make sure you have the flexibility that a robust emergency fund provides in uncertain economic times. For the companies you own in your portfolio do the same thing. Make sure they have the flexibility to survive and prosper whatever the world throws at us.