Balance Sheet Evolution

AdventuresinCapitalism explains why large corporates are vulnerable to a crisis like Covid19.

Excluding brief periods of exuberance at the end of the 1920s and 1960s most public companies historically were staid organizations—they grew a few percent a year and paid out some of their profits in dividends. Boards of directors were mainly recruited from large shareholders who were more focused on sustainability than quarterly numbers or pushing the share price. Sure, there were outliers, there were guys doing crazy things, but a large portion of corporate America was focused on building long-term wealth for the large shareholders (often the families who controlled these businesses).

Then came Mike Milken and his cohort of extortioners and restructuring artists. Don’t get me wrong, by the 1980s, many US corporations had grown fat and a bit lazy—a good shake-up was needed, but the following generation of financial engineers took things too far. I’m all about improving returns on assets (ROA)—my gripe is that the focus then shifted to returns on equity (ROE). Here’s a simple exercise, take a mediocre business, add ten turns of leverage and then marvel at how amazing the returns to equity are. For the past generation, every corporate executive has undertaken a similar exercise and congratulated themselves on the results. For the holdouts who refused to lever up, there was a wolf-pack of hedge funds ready to pounce and educate them on why returning too much capital to shareholders was necessary. Is it any wonder that corporate balance sheets are such a mess today? Like a wounded gazelle, if your leverage ratios were low, you were pounced upon and told to lever up.

Twelve years out from the GFC, businesses should have had strong cash reserves.

There was no rainy-day fund. There was no excess capital beyond a revolver that lasts only a few weeks at best. What should have been excess cash reserves were squandered long ago on buybacks at all-time high multiples.

When we are through crisis, these corporates will have to pay down some of their debt, and increase cash reserves and shareholder equity. That will significant reduce the return on equity, putting pressure on share prices.

As we come out of this COVID-19 crisis, I suspect that Directors will demand larger liquidity buffers. How much of a buffer? What if you need six months of op-ex in cash on the balance sheet? What if Directors demand Japan style balance sheets? What happens when you take leverage down at most corporations? You end up with middling ROEs and reduced valuations (like in Japan). I suspect that ROEs across corporate America are going to converge towards a new and much lower level.