Debt in the World: How Dangerous Is It Out There!

Investment Perspective – July 2015

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price… the cash up value. What matters more is the economics of the business” 

Peter Flannery

The fact is there is a lot more debt in the world than there was even 10 years ago. 

China’s debt increase has been well publicised. Although their shadow banking industry seems to fly under the radar, if you are not familiar with it this is the off bank balance sheet lending that has been building up over many years to what is usually lower quality loans to borrowers that will be less resilient when things get tough. The main problem here is the sheer scale of the shadow banking industry. An event that triggers a major default in this area would impact on the global economy.

Getting straight to the point, there are a lot of numbers and statistics that can cause us concern. These things are valid and real. The real question though is whether they matter?

There is no question that the combination of significant debt and reduced ability to service the debt whether it be China, the US, a large global conglomerate, a business down the street or the household budget, will be challenged when debt servicing becomes the real problem.

The debt is one thing. The debt servicing is quite another.

In the end most things come back to cashflow. Households do. Cashflow in fact is at the very core of financial success for mums and dads and households.

Small to medium enterprises live and die every day as a result of cashflow. Of course, for small businesses they know (hopefully) that profit and cashflow are two different things.  Profits can be rising but cashflow can be dropping.

Large economies such as Japan need economic growth to service its significant debt load. 

Interestingly, Japan’s economy has basically faced serious deflation over the last 20 years or so and yet its citizens still enjoy largely a first world lifestyle. 

Yes it is on the back of debt and more recently printed money but prior to that it was on the back of a highly productive and growing economy. The point here is that their resilience was on the back of economic productivity rather than debt. Their debt has come along as a result of unsuccessful bank bailouts placing the burden on everyday Japanese citizens.

So What?

The world is a more dangerous place financially than five or 10 years ago. Debt levels are higher, debt servicing is more stressed and risks greater.

To be clear, those risks are not just for people investing in property in the sharemarket. As the people in Greece can tell you, those risks also extend to those investing in the bank. The challenge for everyday people is to understand where we are in the economic cycle to know where to put their money. In the end, quality assets are the best place, and specifically quality assets that will grow.

The Common Mistake

Inexperienced investors often make the mistake of confusing price and value. I know you have heard this from me before.

Just because the price of something rises (residential property, the price of gold, the price of shares) does not necessarily represent a corresponding increase in the underlying value of that investment.

FUN FACT: Actually, gold is not an investment – it is a commodity. There is no income or cashflow from gold (unless we are in the business of trading gold or operating a gold mine).

Anyway, cashflow and its relationship with the amount of money that you and I invest is not rocket science but key to successful investing.

If I pay a lot of money for an investment whose price is rising fast then I hope that whatever drives the prices high will continue. Often it does. Just as often it does not.

If we understand what drives the cashflows and the underlying economics of an investment then we are better placed to make good decisions with our money (i.e. put it in the right place at the right time).

There Is Lots of Risk and …

… there is lots of opportunity too.

For many of my clients in the midst of the global financial crises we began investing in the US sharemarket. No, that is not something that everybody was doing.

A number of my clients will remember Apple and the uncertainty surrounding that company after the loss of Steve Jobs.

The opportunity there was to look through the market banter and the noise to understand the underlying business economics. 

Although there is more to it, we could see a strong balance sheet with one-third of the company’s balance sheet in cash. We could see a strong use of capital, minimal debt and consistent profitability. Further, we could see a sustainable competitive advantage along with strong branding on a global scale. Better still, the trading price of the shares were then under pressure and the company was relatively inexpensive.

We did not speculate on the share price of Apple or try to time the markets. Rather we analysed the underlying business, established a valuation and, out of step with most of the market invested with confidence. 

Note I said we invested.

Notice I did not say we speculated.

 Does that make sense to you?

“I have worried about a lot of things in my life…once it actually happened!“

Mark Twain