A New Paradigm

Our last post dealt with the mechanics, or “financial engineering”, available to capitalists currently in which low cost debt can be used to improve return on invested capital (ROIC) by using debt to buy back or reduce outstanding shares (or equity capital). As we explained, the reason for this is the current arbitrage that exists between the cost of debt and equity capital.

In addition to repurchasing or reducing equity capital, availability of low cost debt capital can be used to acquire undervalued businesses. This is what happened in the 1980s in the great “leveraged buy out” (LBO) wave, which lasted from 1982-1989. During that period there was a significant number of corporate takeovers fueled largely by debt. Some of the larger examples of takeovers during that period included Beatrice Companies, Revco Corp, Jim Walter Industries, Federated Department Stores, Uniroyal Goodrich, and Hospital Corporation of America. Capitalists realized that these businesses were under-earning their cost of capital and through restructuring and re-capitalization of the businesses, ROIC could be significantly improved, hence greater return potential for equity holders.

We have something similar to the 1980s occurring in today’s environment. There are many large companies trading at historically low valuations relative to their cash flow potential. The technology sector, for example, is one in which there are a number of large companies trading at very low valuations relative to sustainable cash flow. This can cause a couple of things to happen both of which can be fueled using low cost debt: 1) acquisition of the undervalued companies through an LBO; and/or 2) restructuring and reduction of equity capital base to boost return to equity shareholders.

We believe we are in a “new paradigm” similar to the 1980s. M&A activity has increased in 2013 and is expected to increase further in 2014. Leveraged loans are rising significantly, providing significant capital to fuel this activity. There are a number of very recent examples of M&A activity among large companies including: Sysco merging with U.S. Foods; American Airlines merging with U.S. Airways; and Avago Technology merging with LSI. The combination of slow global and corporate top-line growth combined with continued access to low cost debt capital should enable this new paradigm to continue for several years. This new paradigm should also help to support valuations for public equities and provide fuel for further increases in stock prices.

 

Might Financial Engineering Extend The Bull Market?

For both investing and the economy, cost of capital and return on invested capital (ROIC) are vital concepts. Generally speaking, investment capital will seek its highest return. This is partly what drives stock prices but it also is an important element in private investments and capital spending decisions by businesses.

The past several years have witnessed financial market anomalies not seen in many decades. One of those anomalies currently is the unusually wide disparity between the cost of debt capital and the cost of equity capital. Because of the long decline in interest rates, the cost of debt capital is now very low relative to the cost of equity capital.

Anomalies like this present capital opportunities. Specifically in this case, an arbitrage opportunity exists in which low cost debt can be used to boost shareholder returns (ROIC). How does this work? Say, for example, a large company has a current cost of debt capital of 2% and a cost of equity capital of 8-9%. It might make financial sense for this company to take on debt and use that capital to reduce equity capital through share buybacks. The result of this is higher ROIC.

The potential for exploiting the current debt/equity arbitrage has positive implications for the stock market and the economy. Why? First, it means that capital heretofore not invested in equities can come into the market via acquisitions and share buybacks; and second, capital is allocated more efficiently in the economy, an important benefit.

History repeats itself. We saw something like this in the early and mid-1980s. As interest rates (cost of debt capital) came down during the 1980/81 recession, it allowed strong companies to take on debt and acquire undervalued companies through leveraged buyouts (LBOs). This “financial engineering” process is occurring again and could be further fueled by this debt/equity arbitrage.

From a financial planning perspective, to the extent this arbitrage opportunity can continue over the next year or two, it reflects positively on stocks as an important vehicle for enabling clients to grow their financial assets, meet long-term financial goals, and keep up with inflation.