Many of you are familiar with the statistic that 40% of Americans could not withstand an unexpected expense of $1,000 or more without incurring a deep level of financial hardship. What people have not realized, and are perhaps realizing now, is that over the past thirty years the leading corporations (and even much smaller ones) have put themselves in nearly the same position.
Back in 1990, the median American corporation in the S&P 500 had enough cash to sustain itself for approximately 14 months and credit lines for another 9 months in the event that revenues turned to zero. If the world fell apart for a particular business, industry, or the economy as a whole, the average S&P 500 participant would have a “two year clock” to straighten itself out. Nowadays, the median S&P 500 stock has a little under 2 months of cash and about 6.5 months of financing available through a credit line.
At the mom-and-pop level, these figures are even more exaggerated, as approximately 43% of privately owned businesses report having less than 6 weeks of operating costs on hand as cash. Almost a third have no line of credit in place. For limited liability companies and partnerships, over 60% indicate that they remove the cash profits from the business at the end of the year (due to tax reasons and the nature of business agreements that are of much shorter duration today).
As a result, the typical American business is more fragile to shocks today than in the past. Yes, it is a few-times-in-a-century outlier to have business completely shutdown, as we are seeing during COVID-19, but a successful equity investment of any kind requires the absence of a wipeout event. It is fine and well to watch your balance in Stock X climb by Y% year after year after year, but that becomes all for naught if a liquidity crunch occurs and the business heads to the bankruptcy courts with the debtholders to replace the existing shareholders as the owners of the business.
When you see these wild 10% daily swings in the stock price of companies in the entertainment, retail, auto, hospitality, and restaurant stocks, it is a function of a lack of liquidity that is leading the investor community to value the company in a binary manner, as in, “If the shutdowns are over in 1-2 months, we can value this company using traditional metrics and earnings expectations from earlier in the year. But once this extends into months 3 and 4, the prospect of insolvency and a total shareholder wipeout looms.”
For example, in the case of the four major U.S. airlines, they are looking at 90% declines in domestic air travel right now. They have the cash on hand to make it through May or June without accessing their credit lines of credit. And then that would carry them until September or October. If they had the balance sheet of a median S&P 500 stock in 1990, the prospect of insolvency would be not be 90 or so days away until May 2021 rather than May 2020. And if the four major airlines had theoretically kept the $40 billion in cash on hand that were used to repurchase shares over the past decade, they would face an equity wipeout until 2023 under circumstances where 90% of revenues decline.
I suppose this is part of the reason why I was drawn to Warren Buffett and Charlie Munger. For the past thirty years, corporations have been obsessed with using share repurchases to grow earnings per share and risking the health of the corporation to do so. Heck, in 2019, 138 stocks in the S&P 500 spent more on dividends and share repurchases combined than they earned in profits. Think about that–for over a fifth of the index, not only are there no cash reserves being retained for a rainy day, but the corporation is actually being actively indebted in the service of share repurchases.
I am not naive about the political and institutional pressures that face corporate executives. Businesses that accumulate significant cash often draw the attention of corporate raiders who have ideas on how that cash should be spent right now to bolster returns. High debt for a corporation is a defense of sorts against takeover activity because the acquirer has to take over the debt as well. And also, wise/conservative stewardship often means lower earnings per share compared to peer companies in good times that are using all available cash to retire shares.
Interestingly enough, it is the largest ten corporations in the United States that are sitting on some of the largest cash piles (otherwise, you need to look to family-owned or corporations with large insiders that can ward off a would-be corporate raider from a cash pile). A business like Microsoft not only is seeing its sales explode during the shutdown, but aside from that, it has over $130+ billion in cash to withstand turmoil. If it were somehow affected by COVID-19, it could in theory cease earning revenue for 10+ years before facing corporate insolvency.
It is disappointing that so many S&P 500 index components are not equipped to even handle three months of a “Great Depression Lite” without folding. The disappointing part is that many of these businesses are perfectly decent compounders that could deliver 10-12% annual returns to shareholders over a multi-generational timeframe if adequately funded. Maybe a federal government bailout will pave a path for that to happen anyway, but nevertheless, millions and billions of dollars in future possible wealth should not hinge upon the arbitrary decision of Uncle Sam to put funds in the corporate tin cup when requested.
The good news is that the corporations with strong balance sheets are readily identifiable and there are at least 25-40 of them in the S&P 500. You only have to find one investment at a time, and undervalued corporations with strong balance sheets are out there (and obviously covered heavily by me over at Patreon) for you to acquire ownership. When you see minimal debt and significant cash piles on the balance sheet, the COVID-19 pandemic is a blip in operations rather than an existential threat. Also, I should note, the experience of owning cash-rich corporations is far more enjoyable than owning overleveraged junk because management teams that are conservative with cash tend to be equally cautious in other aspects of operations and I personally find that management teams capable of building surpluses and letting them sit for awhile to be especially trustworthy stewards of capital.