Debt, if used wisely, can be a valuable financial tool. But as the famous economist John Kenneth Galbraith warned: “All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.”
In 2008, South Africa could boast a comparatively low debt/gross domestic product (GDP) of 28 percent, below emerging market and global averages. However, through the Zuma era total government debt has doubled to 56 percent of GDP, with the result that our interest costs to GDP have more than doubled - to more than 5 percent of GDP. Is this now too high?
Despite our deteriorating debt profile, we don't believe we have reached crisis levels - yet. This is primarily because of the long maturity profile of our government debt. Indeed, South Africa has a more favourable (ie, longer) maturity profile than most countries (second only to the UK). Additionally, the government has belatedly grasped the critical importance of limiting the growth of the debt burden and has arguably already started down the long road to achieve this and to reinvigorate economic growth.
This is not to say that our government debt is not a serious cause for concern - it has been the major factor in our sovereign downgrades and has made interest repayments highly costly for our society. Risks also remain for further downgrades. Yet importantly, Prudential believes the real returns on offer from longer-dated government bonds (around 3.5 percent), largely provide investors fair compensation for these risks.
In the South African equity market, we estimate that companies’ average net debt/capital ratios (ex-Financials) have risen from conservative levels (below 20 percent) in 2011 to more than 30 percent. Note that averages hide extremes at both ends and certain companies entered 2018 with net debt/capital levels more than 40 percent.
As global growth started slowing in 2018, operating conditions became more challenging for many corporates. The US Federal Reserve also hiked interest rates further.
As Warren Buffet says, “the tide went out”. Those companies exposed to be “swimming naked” were those whose leverage had grown too large in relation to the underlying means of payment.
Clothing retailer Edcon was saved from certain failure by its creditors and landlords swopping interest and rent payments for equity. Numerous listed stocks suffered a difficult second half of 2018, partly as a consequence of their relatively elevated leverage, including Anheuser-Busch InBev, which had to slash its dividend to calm equity investors British American Tobacco (BAT), many local property stocks, Ascendis, Aspen and Tongaat Hulett.
As an investment manager, we have attempted to navigate most of these “debt bombs” by focusing on balance sheet strength, but also on understanding companies’ debt maturity profile and free cash flow generation.
For example, both Aspen and BAT had high leverage and their share prices came under pressure in mid-2018.
Our decision to sell Aspen was driven by its deteriorating working capital cycle, which would likely negatively impact cash generation and in turn be insufficient to deal with the company's unfavourable debt maturity profile.
On the other hand, buying more BAT was driven by our view that its near-term cash flows would remain sufficient to both support a high dividend (6.5 percent) and de-gear the balance sheet. These decisions contributed considerably to the outperformance of the Prudential Equity Fund in the first quarter of 2019.
In conclusion, at Prudential we invest across companies that have vastly different levels of financial leverage and do not specifically exclude those with high leverage. We aim to understand balance sheet strength and the company's ability to repay debt.
While high leverage increases a company's vulnerability to economic downturns, if you can conclude that the reward on offer compensates for the higher risk involved, such companies can represent excellent opportunities to add extra portfolio returns.
Johny Lambridis will be presenting at the Allan Gray Investment Summit.