Many people who establish trust funds for their kids or some other beneficiaries tend to include restrictions on how the investment funds are to be allocated. A common clause is to state that all stocks and corporate debt in the trust must be classified as “investment grade.” On the surface, this provision sounds intelligent enough. Of course funds meant to last for long haul should be invested in durable companies. Very few durable companies have debt that is not classified as investment-grade during good and ordinary times.
However, it is also true that some durable companies tend to have their credit ratings slashed during recessions and other unanticipated deterioriations such as the spread of COVID-19.
To use a local example, I live in St. Louis and many trust funds contain a disproportionate amount of Anheuser-Busch Inbev (BUD) stock because Anheuser-Busch was originally found in the city and the decades and decades of prosperity and bounty created by the company were displayed firsthand to myself and the other residents.
At the present time, Anheuser-Busch carries over $100 billion in debt as a result of the 2008 Inbev / Anheuser-Busch merger and as a result of the subsequent SABMiller acquisition. With restaurants and sports venues closing as a result of COVID-19, profits will be down while the debt remains. It is entirely possible that Anheuser-Busch stock could be downgraded to below investment grade as the COVID-19 economic shutdown continues.
Think about the implications of how this trust fund contractual provision could interact with a large position in Anheuser-Busch suffering a debt downgrade. Imagine a trust fund that contained 7,500 shares of Anheuser-Busch. In 2016, the value of the BUD stock would have been $1,020,000.
During the worst of the COVID-19 panic so far, BUD stock traded as low as $34 per share. Those same shares would now be worth $255,000. If the company were to experience a debt downgrade, and if the stock were priced accordingly, a provision requiring a trust fund to only contain investment-grade debt would require locking in a loss of 80% on the Anheuser-Busch stock even though the company’s future compounding prospects are dramatically brighter when evaluated from a $34 entry point compared to $136.
The takeaway lesson is that mechanical rules sound conservative and wise in theory, but can be destructive in the application. I see it every day–some trust containing a provision about automatically selling a stock in response to a ratings cut somewhere, or even income investors automatically selling a stock because it has cut its dividend. What the conservatism ignores is that, at a time when a condition is broken, the company is likely valued quite low and facing some type of enormous but solvable problem.
And COVID-19 is going to present many enormous, but solvable problems. Automatically selling a stock in response to it does not make sense. It is, more times than not, selling low. A mechanical rule, such as selling a stock once its debt is classified as below investment-grade, could very well require selling at lows when the future compounding rate will be at its greatest. For better or worse, decisions have to be made on an individual basis in real time. My idea of planning is having enough resources to withstand adversity rather than making a set of rigid rules set out in advance to mechanically follow when the adversity arrives.
