We Just Can't Kick Our 'Debt Addiction'

Let the deleveraging begin... When big deals go wrong... Corporate America's debt addiction... Do they ever learn?... Liquidity is like oxygen... 'Late-cycle' behavior...

Editor's note: Digest editor Justin Brill will be back from vacation next week. In the meantime, Extreme Value editor Dan Ferris continues to "pinch hit" for Justin as part of our coverage of the markets... Today Dan shares his thoughts on the dangers of our continued "debt addiction."

Let the deleveraging begin...

Last week global mega-brewer Anheuser Busch-InBev (BUD) announced the sale of its Australian unit, Carlton & United Breweries ("CUB"), to Japan-based brewer Asahi for an enterprise value of $11.3 billion, a measure that includes debt.

AB-InBev is selling this mature business to pay down some of its massive $106 billion debt load, equal to more than 4.5 times the company's earnings before interest, taxes, depreciation, and amortization ("EBITA") since 2016.

That's when it spent about $99 billion to buy South Africa-based SABMiller. Now, the beer giant is looking to trim its debt to 4 times EBITDA sometime this year.

Why is this so important to note today?

Well, it's typical to see big companies levering up to do big deals like these near market tops.

In today's Digest, I'll show you that we've seen this story before... explain what I (Dan Ferris) and others are seeing today in the credit and equities markets... and describe why it's so important for investors of all types to pay attention to our "debt addiction."

If at first you don't succeed, try again...

AB-InBev's sale of CUB came one week after its ill-fated attempt to sell its Asia unit through an initial public offering ("IPO").

The move failed because investors thought the valuation AB-InBev sought for those businesses was too high: $54 to $64 billion, according to the Financial Times.

Before that, AB-InBev cut its dividend 50% last October and said it would use the $4 billion extra cash flow to pay down debt...

And it wasn't the only heavily indebted company with similar thinking.

Less than a week later, embattled industrial conglomerate General Electric (GE) lowered its dividend to $0.01/share from $0.12, primarily to help pay down debt.

And there's plenty more...

AB-InBev and GE are both part of the elite group of non-financial companies with more than $100 billion in debt, which also includes AT&T (T), Apple (AAPL), Comcast (CMCSA), and Verizon (VZ), according to data compiled by Bloomberg.

Asahi's takeover of CUB is typical of huge, leveraged late-cycle deals, ones that any of these companies could make. But they should be wary...

The liabilities of these big deals aren't limited to the amount of debt taken on to do them...

Just ask German pharma/consumer giant Bayer...

Bayer paid $63 billion for chemical dominator Monsanto last year, and took on $24 billion in new debt to do it.

Bayer's share price has been in freefall much of the past year, reacting to headlines that Monsanto's glyphosate-based Roundup weed killer causes cancer. U.S. juries have awarded more than $2 billion in glyphosate-related damages, and more than 13,000 cases have yet to be decided.

The situation has taken its toll...

Bayer announced three asset sales and 12,000 job cuts in November. It sold its Coppertone sun protection business in May for $550 million.

It's selling its animal health unit for $8 billion (a deal that's yet to close), and today, Bayer announced the sale of its Dr. Scholl's footcare business to a private equity firm for $585 million.

The spin is that it's all designed to refocus Bayer on its core businesses. I believe that's code for "We're selling what we can so we don't get burned by our stupid decision to lever up and buy Monsanto."

Big deals often create headaches, leading to asset sales and "restructurings"...

And it's no coincidence that AB-InBev, GE, and Bayer all made big restructuring announcements in October and November, as the stock market went into freefall after a series of Federal Reserve rate hikes.

Everything is hunky-dory when the stock market is going up... Corporations do big deals. They take on more debt. They party like it's 1999.

Then the Fed pulls away the punch bowl, the lights come on, and suddenly investors realize corporate America has been wearing beer goggles for 10 years.

When stock prices start falling, investors start thinking about which stocks to unload.

First on the list is companies with big debts.

Bayer, for instance, got killed in the market rout last fall. Its shares tumbled 45% from October through Christmas Eve.

This dynamic is an old story... Warren Buffett wrote about it in 1992 in Berkshire Hathaway's annual report:

In the past, I've observed that many acquisition-hungry managers were apparently mesmerized by their childhood reading of the story about the frog-kissing princess. Remembering her success, they pay dearly for the right to kiss corporate toads, expecting wondrous transfigurations.

Initially, disappointing results only deepen their desire to round up new toads. ("Fanaticism," said [philosopher George Santayana], "consists of redoubling your effort when you've forgotten your aim.") Ultimately, even the most optimistic manager must face reality. Standing knee-deep in unresponsive toads, he then announces an enormous "restructuring" charge. In this corporate equivalent of a Head Start program, the CEO receives the education but the stockholders pay the tuition.

Global merger and acquisition ("M&A") activity fell to $842 billion at the end of the second quarter of 2019, down roughly 13% from the first quarter. Trade tensions contributed to big drops in European (down 54%) and Asian deals (down 49%).

But U.S. mega deals helped keep the U.S. M&A decline at just 3%. These included the $121 billion merger of United Technologies (UTX) and Raytheon (TRN), and pharma giant AbbVie's (ABBV) $63 billion takeover of Botox-maker Allergan (AGN).

As long as cash flows are adequate, ratings agencies love to play along...

Good ratings help institutions peddle debt securities, helping investors justify owning them.

More than half of the $5.6 trillion corporate credit market is now rated BBB – the lowest investment grade rating – by agencies like Moody's and Standard & Poor's. (Investors love BBB, too. They figure, "Hey, it's safe because it's investment grade. It's not junk like that nasty old BB stuff." BBB-rated debt returned 11% last year, much better than any of the more speculative-rated debt classes.)

I find it the most convenient coincidence that more debt is rated BBB than any other...

We've mentioned this anomaly before.

It's so obvious that the ratings agencies are doing the bidding of their corporate clients... That then helps their clients add even more leverage to their balance sheets and do more trashy deals destined to blow up.

It reminds me of how mortgages were sliced and diced and put into toxic vehicles called collateralized debt obligations, or CDOs... which magically earned them higher ratings – often AAA, the highest rating – than if they weren't bundled up.

Is there any doubt that one day soon, the pig behind all that ratings agency lipstick will be revealed, and some huge portion of those trillions of BBB-rated debt will descend into junk territory, as ratings agencies play catch-up with reality?

It makes you wonder how this sort of thing happens a second time...

You'd think the financial crisis would have cured the world of its weird debt addiction forever.

John Kenneth Galbraith, the Canadian-born economist, wrote about this in his classic essay, A Short History of Financial Euphoria. I highly recommend giving it a read. Galbraith named "extreme brevity of the financial memory" as one of the causes of euphoric episodes that precede financial crises.

... when the same or closely similar circumstances occur again... they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliant innovative discovery in the financial and larger economic world.

There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.

And it's not just corporate America...

At this point, I'm not just talking about corporate America's tendency to lever up and buy things near market tops. I'm also talking about investors' lack of memory of how poorly leveraged instruments tend to treat them over time.

Our friend Jason Goepfert over at SentimenTrader wrote about a current example of that on Friday:

The smallest of options traders placed a record bet on a stock decline in late May and early June. Now that stocks have done the opposite, they're moving to the other side of the boat.

Last week, they spent 40% of their volume on speculative call options, one of their most leveraged bets on a rally since 2000.

From big corporations buying other companies to small investors buying call options, there's one condition that investors tend to take for granted, the underlying condition that all speculative excess leans on heavily...

I've told this story before, but it bears repeating today, and you should probably get used to hearing it from me until the S&P 500 is about half its current levels! It's from writer David Foster Wallace's now-famous 2005 commencement speech at Kenyon College.

Two young fish swim along, and are greeted by an older fishing swimming the other way...

The older fish says, "Good morning, boys. How's the water?" The two young fish just smile and keep swimming. Then one says to the other, "What the hell is water?"

In the story, water is that ubiquitous substance upon which the fish's life depends, but of which at least one remains blissfully unaware.

Wise traders understand this well. They liken liquidity to oxygen: You're unaware of it until it's not there.

Liquidity is an investor's ability to buy or sell instantly without moving the price. The more actively you trade your account, the more you take it for granted.

When investors, corporations, and other financial actors lever up to take risk, they're assuming they can reverse their decision without too much trouble...

Oddly, the painful restructurings I reported on earlier provide the liquidity-enhancing events that only reinforce future corporate decisions to take on debt to buy assets.

They would only discourage future mistakes if the folks making the decisions gave half a crap about the outcome for people holding the securities involved.

But corporate capital allocators' compensation usually isn't tied to actually doing their job well, so they generally don't care what happens to the stock and bonds they sell.

They figure, "Hey, if it doesn't work out, we'll just sell"... same as all those little options traders Goepfert says are now massively long stocks. They go in knowing they can get out fast.

But what happens if you can't sell without losing another 20%?

That's what happened to folks who sold Facebook (FB) shares in a matter of minutes in after-hours trading on July 25, 2018.

The company lost roughly $119 billion of market cap, the largest one-day market cap loss in history. Imagine you're holding a stock that just traded for $215 per share, and you'd like to sell... and the next bid is $180.

That's just about what happened to Facebook's stock in this case. And if it can happen to a megacap stock like Facebook, it can happen to just about any asset you can name. Any stock. Any bond. Any option. Anything. Anywhere. Any time. The water can evaporate.

Facebook recovered and now trades above $200 per share. Longtime readers of Extreme Value and listeners to the Stansberry Investor Hour podcast know I've been critical of Facebook, but I'm not an idiot.

It's an incredible, cash-gushing business, the likes of which the world has never seen... which makes it all the weirder that liquidity for its shares could evaporate like that.

Maybe the water is already evaporating on a broader scale... Goepfert also reported on Friday that the SPDR S&P 500 Fund (SPY) – the most liquid-traded stock in the world – recently closed at a new high, but "nobody seemed to care – its range and volume were the lowest in months. We've never seen this outside of holiday-influenced sessions."

Liquidity problems don't tend to hit equity markets until they've done plenty of damage in credit markets... damage that may be starting to ramp up.

Author and investment banker Christopher Whalen recently published a short list of what he calls "non-bank default events" that have happened since June.

I'd call them liquidity events.

Whatever you want to call them, these sorts of events are exactly the kind you've long heard Porter and his team talk and warn about... the type of events that can create a wave of bankruptcies (while also opening the door for tremendous opportunities, as my colleague Mike DiBiase identifies in Stansberry's Credit Opportunities).

One of the events Whalen notes in his piece, "As Stocks Rise, Liquidity Falls," is the Chapter 11 bankruptcy filing of Stearns Holdings, the parent company of Stearns Lending, which makes home loans. He writes:

"Stearns Holdings, the parent company of residential mortgage lender Stearns Lending, filed for Chapter 11 protection [in early July] after agreeing on a debt-restructuring plan with majority owner Blackstone Group (BX)," reports The Real Deal. Stearns previously sold its servicing portfolio to Freedom Mortgage to raise cash. Blackstone is trying to wipe out almost $200 million in bond debt in the bankruptcy but preserve its equity control. PIMCO owns most of the Stearns debt, making it unclear who is going to end up with the assets and the Stearns lending business.

If the name Stearns sounds a little familiar, it might be because founder Glenn Stearns' new reality TV show, Undercover Billionaire, debuts this Wednesday night on the Discovery Channel.

Viewers will watch as Stearns starts from scratch with nothing but a pickup truck and $100, with a goal of making $1 million in 90 days.

If he succeeds, he'll give the money back to the people who helped him along the way. If he fails, he'll pay each of those folks $1 million of his own money.

According to the Discovery Channel's website, Stearns started out dirt poor in Maryland, becoming a father at the tender age of 14... worked his way up, and then sold his mortgage business for $2.2 billion a few years ago.

Though he's been out of the business for a few years, and it's possible the bankruptcy has nothing to do with any actions he took... there's still something creepy about him going on TV under the premise that he's a business genius, as the company he founded goes bankrupt...

But why should we expect anything different? This has late-in-the-cycle written all over it too.

Before I go...

On Friday, I tried to get the gold bullishness out of my system...

But I couldn't help but notice that Ray Dalio, founder of Bridgewater Associates, the biggest hedge fund in the world, wrote recently, "I believe that it would be both risk-reducing and return-enhancing to consider adding gold to one's portfolio."

His advice appears at the end of a more detailed report on financial paradigm shifts. Dalio describes a future of massive financial upheaval:

... there will have to be some combination of large deficits that are monetized, currency depreciations, and large tax increases, and these circumstances will likely increase the conflicts between the capitalist haves and the socialist have-nots. Most likely, during this time, holders of debt will receive very low or negative nominal and real returns in currencies that are weakening, which will de facto be a wealth tax.

Dalio says he'll write a new report soon on why gold makes a good portfolio diversifier.

Bottom line: As I sign off today, my gold-obsessed brain is doing what human brains do, and seeking confirmation everywhere it looks.

So here I am again, after swearing to get gold off my chest just three days ago.

I'll take another crack at it on Wednesday...

52-week highs (as of 7/19/19): Franco-Nevada (FNV), Lundin Gold (TSX: LUG), NVR (NVR), Royal Gold (RGLD), Sandstorm Gold (SAND), Sprott (TSX: SII), and Wells Fargo – Series W (WFC-PW).

A quiet weekend in the mailbag. As always, send your comments, questions, and concerns to feedback@stansberryresearch.com. We can't provide individual investment advice, but we read every note.

Good Investing,

Dan Ferris
Vancouver, Washington
July 22, 2019