In the early 1990s, American investors could choose from over sixty publicly available investments in companies whose debt issuances were rated as AAA, the highest possible credit rating which denotes the lowest rate of foreseeable default that exists in the world of debt instruments.
3M, Amoco (now BP), ADP, Campbell Soup, Chevron, DuPont, Exxon, General Electric, Getty Oil, IBM, Kellogg, Kraft, Procter & Gamble, Pfizer, Merck, and Ford all had AAA-rated debt. In 2019, the only companies left in the United States with AAA-rated debt were Johnson & Johnson and Microsoft (Johnson & Johnson and Microsoft sit on $19 billion and $127 billion in cash, respectively).
When Moody’s, Fitch, and Standard & Poor’s rate the debt of a company, they look at the following factors:
- Earnings growth;
- Profit margins;
- Revenue growth;
- Future industry outlook;
- Tax burden;
- Pension obligations;
- Regulatory climate;
- Intellectual property, including trademarks and copyrights;
- Distribution channels;
- Economies of scale;
- Historical industry stability;
- Ability to withstand recessions; and
- Debt load, particularly as they relate to cash flows.
The factor relating to debt load is the leading reason why companies have disappeared from this list.
The management of any leading company has to make a decision: Do we want to be able to survive a recession that matches the worst we’ve seen in our lifetimes, or do we want to be strong enough to survive a once-in-six-hundred-year event such as the Great Depression? During the past-decade period of low-interest rates, companies have leveraged their cash flows to the highest amount possible.
It was just 2014 that Apple had over $100 billion in cash and only $28 billion in debt. Now, it has $122 billion in cash and $114 billion in long-term debt. It remains a financial fortress, but also, an ever-growing portion of future cash flows are now spoken for. The shareholders of the 2030s and 2040s will be paying back the debt that was used to repurchase 1.3 billion shares of Apple stock between 2014 and 2019. Buybacks are why earnings per share have doubled at Apple since 2014 even though profits have not doubled–growing from $40 billion to $62 billion over the same time frame.
The question for individual investors is, of course, what is the long-term implication of monstrously strong businesses evaporation from the landscape?
My answer is two-fold.
First, there is something to the notion of loading up on shares of Johnson & Johnson and Microsoft, and the near AAA-rated companies, Alphabet, Automatic Data Processing, Berkshire Hathaway, and ExxonMobil, when the price is right. These companies have been conservatively financed for decades, and this inculcated culture and strong balance sheet serves as an important part of the basis for holding shares of these companies on your family’s balance sheet for long periods of time.
Second, weaker balance sheets mean it is more important to invest in companies that keep the cash flows coming during poor economic conditions. If you invest in a firm that has a high debt load, you better be certain that the earnings power will remain intact during economic hard times otherwise your investment will be diluted at an unfavorable price point or wiped out entirely if debt comes due that cannot get paid. In practice and almost by definition, this is what causes an investment to get wiped out.
For example, I have never followed Warren Buffett into airline stocks, particularly Delta. You know why Delta fell to $3 in 2009? Because billions of dollars in debt were due and the company lost $1 billion that year. Today, it carries $10 billion in debt, and $8 billion in debt is due within five years.
If a business climate like 2008-2009 were to return between 2019 and 2024, and if that business environment were to last two years, stockholders would get wiped out (unless Delta was bailed out via a loan from Berkshire like Buffett did with Bank of America in 2011). But in such a case, the shareholders would be wildly diluted. Even though a lot of money has been paid over the past decade riding the stock up from below $10 to the current price of $48 per share, I have no interest in the stock because the long-term investor has a reasonable risk of wipeout or heavy dilution during awful economic conditions. The balance sheet matters.
Low interest rates and boom times have made it easy to ignore the importance of balance sheets when evaluating a stock. Acquiescing to this status quo is a mistake. Just ask the Citigroup shareholders who saw the company issue 400% new stock at a price of $15 per share in 2008-2009 and are now sitting on a loss of 75% of their capital over the past decade even while the annual profits have climbed from $3 billion in 2002 up to $18 billion now.