With the first Fed rate hike of 2018 likely to occur later this month, we’re going to start hearing a lot more about debt.
As interest rates rise, companies that have become excessively leveraged during an era of cheap borrowing may find the rising costs of that debt punitive.
Why does this matter to long-term investors like ourselves? Quite simply, too much financial leverage puts a business model at risk, especially in more difficult operating environments. We have seen this time and again throughout the business cycle, where paying liabilities becomes more difficult as earnings and cash flows fall. This, in turn, could adversely affect growth plans and put pressure on dividends. Credit markets also price-in more risk through higher yields and, as investors fret over a company’s ability to pay its dividend, there’s the knock-on effect of lower equity pricing.
Credit analysis is therefore a fundamental part of our investment process to identify and avoid overly levered companies. For instance, in February, we sold a US semiconductor manufacturer for exactly this reason. The company has a diverse portfolio, consisting of many products where it is a market leader, either through technological advantage or scale, and our original investment thesis assumed a continued strategy of small, bolt-on acquisitions. However, its attempt to acquire a rival involved a very large level of incremental debt (greater than US$1 billion) at a potential peak in the semiconductor cycle. And all at a time when interest rates might rise considerably. As a result, we felt the company no longer passes our credit analysis and the risk/reward for shareholders had worsened.
Time spent analysing company balance sheets to ensure they are appropriate for the type of business a firm is undertaking is always incredibly valuable. But we believe this kind of work will become even more relevant in the ‘new normal’ of higher rates.