According to Warren Buffett the first rule of successful investing in not to lose money and the second rule is not to forget the first rule. With this sage advice in mind, what are the risks in today’s aging stock rally, both in the USA and abroad? Our considered opinion is that the soft underbelly of the bull market is too much debt. This debt excess includes that held by consumers, governments, and businesses.
Business Debt and Margin of Safety
When Steve Jobs came back to Apple he reinvigorated the company and generated lots of profits. He also built up a huge stash of cash so that the company would have a margin of safety in case of a business downturn.
Successful long term investors look for stocks that are likely to provide strong cash flow, return on investment, and a degree of security over the years. The security in owning a good stock comes from its margin of safety. The official definition of margin of safety is that it is the difference between the market price of a stock and its intrinsic value. However, there is more to the intrinsic value of a stock than a quick look at expected financial over the years. Finding the margin of safety of a stock may be easy and finding the margin of safety of a stock may take a little research and thought.
Money in the bank instead of excessive debt is a comfortable margin of safety. Netflix has been in the news again as its stock price keeps going up but Netflix is not making a profit even though they are increasing their market throughout the world. And Netflix repeatedly takes on debt to fund movie production and other costs. Amazon.com is another case in point as they borrowed in order to take over Whole Foods. The stock price is up on growth but their ratio of debt to cash on hand is going up. On the other hand Apple ended 2017 with a quarter of trillion dollars in cash reserves and Microsoft has about $125 billion in reserve. When considering how to prepare for a market correction remember that the soft underbelly of the bull market is too much debt and look for a margin of safety when you invest.
China has experienced economic growth over the last decades similar to what the USA saw from the years after the Civil War and again in the mid-20th century. They have been able to take on both business and consumer debt because the economy has continued to grow. But, all good things come to an end. China’s debt is not worrying investors both at home and abroad. The soft underbelly of Chinese debt is a risk to Chinese businesses and consumers and to a world full of commodity exporters who rely on China to buy their raw materials.
The Economic Times provides an example of a Chinese port with few ships that is not making money and a debt burden.
Each year roughly 60,000 ships vital to the global economy sail through the Indian Ocean past a Chinese-operated port on the southern tip of Sri Lanka. Almost none of them stop to unload cargo.
The eight-year-old Hambantota port – with almost no container traffic and trampled fences that elephants traverse with ease – has become a prime example of what can go wrong for countries involved in President Xi Jinping’s “Belt and Road” trade and infrastructure initiative.
Total Chinese debt has gone from 140% of GDP in 2007 to 256% today. This sort of debt increase invariably ends up causing severe economic damage.
US Tax Cut
The USA has cut taxes, which is probably going to help the economy in the short term, unless a trade war torpedoes the economy. But over the long haul this is another nail in the debt coffin.