Use of Debt and the Importance of Terminal Value

Warren Buffett says "debt is a four letter word." Despite that, I have seen numerous examples of where debt can be useful and where it is dangerous. A recent review of pharmaceutical companies raised that distinction.

In the case of durable consumer products (think Crest or Colgate toothpaste), the brand is well-known and the changes are measurable (e.g., by identifying the market share changes annually, it is possible to identify the durability of a brand). In these situations, debt is appropriate and manageable because the terminal value of the asset is knowable.

For this reason, debt on a home in a decent neighborhood is a reasonable bet for a bank. The bank logically assumes that the home owner is interested in maintaining the home by investing time and money into its upkeep. Thus, given a reasonable location, the home should hold its relative value. In this same reasoning, government regulations forcing lending against homes in poor neighborhoods is a challenge as a home truly depreciates without constant attention.

In this same line of reasoning, pharmaceutical companies did not typically have debt. Initially, I believed that low debt levels were simple a function of having tons of money. Wrong. Instead, these companies identified that patent expiring products tended to have low or unknowable terminal value. When this dynamic is present, debt is extremely dangers. Mallinckrodt (MNK) ignored this dynamic and grew quickly. But since 2015, the stock price has gone from over $100/share to low single digits.

This issue is also relevant to Bausch Health Care (BHC). BHC has a durable consumer line in its Bausch + Lomb product line of eyecare products and borrowed money to purchase it. That is appropriate. However, BHC purchased Salix - a set of GI focused, patent expiring drugs. Those drugs are paying handsomely, but it is important that debt paydown occurs at the same rate as the expiration of its patents rate. As a good friend of mine said about financing cars, "the car gotta outrun the note."

Leaving "Stuff" Alone

I have a friend who is a Depression baby. Some traits never go away. Despite significant wealth, he keeps used paper towels and the used parts of every old piece of equipment. At one point in our economy's history, these were winning traits because our manufacturing capacity was so limited that these saving traits were advantageous. However, as I have blogged about, our economy is rapidly shifting from manufacturing to services as the point of constraint. Today's opportunities seem to lay in facilitating these services as "platforms" or "aggregators".

"Book value" and "tangible assets" have historically been good measures of intrinsic worth. Yet, increasingly, these are actually indicators of capital intensive businesses with low returns. It's as difficult to think that a big balance sheet is a disadvantage as thinking a big piggy bank is bad. Contrarians and "non-consensus" investors are attracted by the bargain of buying book value dollars for fifty cent pieces. Somehow we are wired to be stimulated by these opportunities, but it's better to leave that "stuff" alone.

Leaving Manufacturing Behind

Bruce Greenwald of Columbia Business School has done a masterful job highlighting the Great Depression's role in manifesting a transition from agriculture to manufacturing. This topic is worthy of a book, not a blog post. Significantly, the Federal Reserve acted stupidly by tightening money punitively at a time requiring loosening. The results created WWII.

The current time is similar in terms of a huge transition out of manufacturing due to increased productivity. Politically, people believe that the issue is simply lower priced labor overseas. While that is partially true, the reality is that productivity gains mean that collectively we are capable of producing at higher levels than we can consume. Manufacturing based economies like Japan and Germany are experiencing deep challenges because it is difficult for them to leave manufacturing behind.

The U.S. economy is doing just that, and has for years. Despite all the political rhetoric and trade tensions, manufacturing is not coming back. It looks like the "services" area is growing and likely to do so for years. This transition affects everything. As a result, capital is less important and talent is more important. Productive capacity is less important and intellectual property is more important. National is less important, but local and global is more important. Conglomerates are less important, while companies that are "platforms" for services are more important.

One disturbing aspect of leaving manufacturing behind is the loss of good "middle class" jobs that allowed for fuller pursuit of the American dream. The transition to service, talents and platforms means that the disparity between the haves and have-nots increase without indicting capitalism. The answer seems to lay in a more radical tax structure that eliminates taxation at incomes below the median incomes. In this way, political structure can support the impact of leaving manufacturing behind, rather than pointing fingers at the wrong figures.

Macroeconomic Growth - Three Key Levers

It is difficult to make money by focusing on macroeconomics as there are inevitably unintended consequences. For example, the huge stock market drop in December of 2018 (the largest since 1931) was a result of the Fed's excessively tight monetary policy. But that surprisingly violent stock market drop led to a reversal of Fed policy over to a looser monetary policy. To forecast on a linear basis any macroeconomic factor is problematic. Despite that, macroeconomic focus can help in not losing money.

There are three primary levers that seem critical. In order of importance, these levers are: monetary, fiscal and regulatory. To understand economic growth, each lever needs to be understood.

The first lever of economic growth is monetary policy. Monetary policy is controlled by the Fed and it is the Fed that fundamentally affects economic growth. Ben Bernanke commented, "economic expansions do not die of old age, they are murdered by the Fed." As pundits talk about the length of our economic expansion, they are referencing a meaningless fact. Time is not the issue; perceived misallocation of assets is. The Great Recession was induced by the Fed, but blamed on the housing market. If the government had overhauled mortgage finance, the journey would have been superior to the Fed's choking the economy and then attempting to revive the dying patient.

The second lever of economic growth is fiscal policy. During the Obama years, a period of strong monetary support, there was little fiscal support. A Republican congress tightened up fiscally in an attempt to reduce deficit spending. While this attempt probably led to a reduced misallocation of funding, it did dampen the ability of monetary policy to generate growth. When Donald Trump was elected, fiscal policy was estimated to improve based on infrastructure spending. But that spending never happened. Instead, huge fiscal support came from the reduced taxes of the Tax and Jobs Act of 2017. The Fed attempted to tighten monetary policy in the face of it, but December of 2018 caused the combined force of monetary and fiscal policy.

The third lever of economic growth is regulatory policy. Regulatory policy is invisible, but critical. The United States has less regulatory constraints than other countries. As a result, our economy moved from agriculture into manufacturing more easily than others (such as Argentina) and is moving into services capably. Japan, for example, has strong monetary and fiscal support, but its regulatory structure inhibits its movement away from manufacturing into services. The result is evident and helps answer the question why the the last decades have been lost in Japan.

Understanding these levers may not make money but can help shape of framework for investing and, probably as important, voting sensibly.