The US Debt fueled Frenzy

Facts pertaining to the US economy
1) The debt binge of corporate America has been well documented in various sources and conveniently ignored as enthusiastic investors continue to chase stock market highs across the years.  Although I am not a macro investor, I do occasionally listen to analysis of the present state of the economy and the spillover effects on the other areas.

2) Certain hedge fund and private equity managers has noticeably tried to leverage up the balance sheet of the companies it owned and conduct share buyback to maximize the valuation of their existing shares, before selling them off for a profit. Although conventional corporate finance suggests this is the right action to do to minimise the weighted average cost of capital and maximise existing shareholder value in low interest rate environments, this only benefits exiting shareholders and not long term shareholders whom have to bear the interest rate burden if business slows and companies cannot refinance at attractive rates.

3) Howard Marks in his book (Mastering the market cycle) also described the boom-bust state of the debt cycle, and how low interest rate led people to over-leverage to pursue unsustainable growth. Disciplined CFOs whom stay at the sidelines will see competitor's stock prices outperforming their own, and capitulate to lemming like behavior by replacing costly cost of equity with cheaper debt financing without real improvement to the underlying business. As stock market continues to outperform via leveraging up, naive investors pile up extending the rally to unsustainable heights. Ultimately, the market moves in cycles and the higher the rally, the stronger the corrections. The same situation existed in the 2008 GFC albeit among a different set of market participants. Nonetheless, due to the large number of variables that may affect economic conditions and the maniac -depressive nature of the stock market, Howard Marks avoids discussing optimal periods to enter / exit, but rather a average up/down approach if the securities are at attractive valuations.

4) From macroeconomic theory, the current contradictory goals of the Federal Reserve to achieve economic growth VS low unemployment and low inflation will certainly lead to lopsided balance of payments across the years. The federal Reserve recent action to conduct purchases of bond ETFs and unlimited QE is to instill confidence in the consumers and companies, and hope the wealth effect in the stock market will encourage consumers to continue to spend and keep the velocity of money stable.  With the recovery of business and consumer sentiment, the Fed hopes that companies will succeed to recover / grow to 2020 BC(Before Covid) conditions. Although the aggressive measures of the Fed to intervene in the debt market to resuscitate the economy is correct, the monetarist view is that the aftereffects of Monetary policy while powerful, has outcomes that are not easily identified and uncontrollable, and also encourages moral hazard and reckless behavior among certain institutional entities. The 2020 AC (After Covid) situation is not as simple as a regression equation. <Insert Covid = Market Crash and Remove Covid = V shaped recovery>

5) Ray Dalio posted interesting perspectives that the continual propping up of the debt market has spillover effects on the equity markets. If US persists to be blissfully ignorant and prints money to erode its debt load, there might be a crisis of confidence in the USD as investors to seek for alternatives as evidenced in the cryptocurrency space. If deleveraging efforts occurs, it might lead to companies having stunted growth as they have to grow their equity base while supporting its debt load. Over-leveraged companies are priced for perfection and are ill-equipped to deal with different economic conditions.

6) Cutting of marketing spend also seem to be a common theme among the earnings podcasts of corporate America, which led me to conclude that the advertising revenue growth of the tech companies could possibly be over-hyped as mainstream companies adopt austerity budgets. I shall not accumulate the <hot> tech companies at its <hot potato> prices unless presented with firm facts that will allow me to reassess their valuations.

7) Although I am not as pessimistic as Ray Dalio to proclaim a potential lost decade for the US, considering the large number of variables in his thesis, I will be apprehensive in investing large amounts of money in the US market especially considering its current valuation. I need to be very vigilant when allocating capital in the US market and only pick stocks that have strong franchises and sufficient margin of safety. Certain over-leveraged companies could be permanently impaired by the aftereffect of the crisis. I need to be certain on the boundaries of my circle of competence and be disciplined to say NO if there are too many variables in the thesis or it belongs to my too hard pile.

Portfolio Decisions for the month of May

I initiated a high conviction buy position on Coca Cola on the month of 12 May 2020 at the price of USD 45.69 as a defensive stock that presents a margin of safety from its previous high valuations. Generally, my general inclination is to not go for high leveraged slow growing US dividend payers (estimated 5-6% or lower as a mega-cap company) as there will be limited capital appreciation upside compared to the small cap and mid cap. However, Coca cola has shown strong operating history in varied forms of economic conditions (From failed Products, world wars, Great depressions, Hyperinflation) and is able to adopt flexible pricing strategies to suit an enlarging sticky consumer base, which view coca cola and its brands as differentiated products to go to.

Upside of KO

The share of mind and strong advertising clout, as well as the design and distribution channels of the product lines created loolapalooza effects that is likely to loop and continue for the foreseeable future. Its large market share allows it to tap on operating leverage as it can control its fixed costs and capex, and lower its average variable costs as it continually grows larger.

Personally, a scuttlebutt analysis through walking through shopping malls led me to conclude that coca cola is still able to generate sales through supermarket chains and fast food chains, which led me to conclude that the operating cash flow should not be hampered too severely in the midst of the worldwide shutdown, and it should be able to support its debt load. Compared to the fast food retailers whom still have to fight tooth and nail to win over the consumer taste buds, Coca Cola is comfortably sitting at the back and tapping on the sale of fast food meals with each complimentary drink. Nonetheless, as global amusement parks and dining outlets are closed with no certainty of reopening for business as economies are hit be secondary / additional waves of outbreak, the 2020 operating cash flows will be very erratic and impossible to forecast. Taking a long term view, this could just be a blib on the radar.

Despite the high leveraged balance sheets, KO has taken steps to improve its Debt to Asset ratio and profit margin (at the expense of revenue) over the past 3 years, and launched calorie free products (Coke Zero and its variants) which has reasonable growth prospects to health conscious consumers, and energy drinks brands which present interesting prospects.

Downsides of KO
Despite marketing itself as an elixir of happiness, there is much to worry about its current valuation and balance sheet. Although KO is significantly cheaper compared to its previous valuations, it is not super cheap from a discounted cash flow perspective, and my cross checking with other online valuations seems to reaffirm this.

Its debt load is worryingly high (which is alarmingly common among US S&P500 large caps) which made me hesitate on my purchase for quite some time. There is also noticeably little insider ownership as evidenced by its managers offloading their positions once they executed their share options. Leveraging up the balance sheet, juicing up the share price, and selling their positions to lock in capital gains seem to be a common theme throughout the short term corporate managers of US MNCs, from Apple, Activision Blizzard, YUM!, Restaurant Brands, Chipolate Mexican Grill, US Airlines, Starbucks and other famous brands.

Conclusion
Considering the over-analysed, overoptimistic and high valuation of the SandP 500 stocks, it is very hard to find sufficiently undervalued stocks in this space. My existing stock filters also do not work well in US market as I prioritized conservative debt/equity ratios. Until there are more facts that allows me to reassess the situation, I shall be conservative while sieving through the 2020 AC (After covid) space.