money advice
Estimating the level of fixed credit costs
On the macroeconomic level, capacity utilization rates are a good indicator for the level of fixed costs of the corporate sector, because the higher the utilization rates are, the less the costs of maintaining the infrastructure to generate one unit of output will be. Furthermore, an increase in industrial output hints at rising revenues and solid cash flows for the companies. This strengthens the companies’ abilities to service their debt. Therefore, credit spreads tend to tighten when capacity utilization and industrial production increase. Yet, rising cash flows tend to invoke business investment, particularly when capacity utilization rates are above average. Historically, levels above 80–82 percent have been a threshold above which the willingness to invest has increased significantly. Like capacity utilization rates, industrial production is a coincident indicator for the state of the economy. Across the business cycle, credit spreads tighten when industrial production grows, and sell off when the economy is doing poorly. Usually, when the economy is doing well, default rates tend to fall and the more positive sentiment usually leads to a lower level of risk aversion. Therefore credit investors settle with lower spreads than in times of poor economic performance.
Growth investing has an addictive quality
Growth investing has an addictive quality. Just as the alcoholic rationalizes away hangovers and arguments in the belief that the next bottle will bring happiness, the growth investor rationalizes away P/Es, asset prices, burn rates, and all other measures of financial value for the dream of finding the next Microsoft. When growth slows and the stock price collapses, unhealthy investors try to get even. Rationalizing away the recent collapse, they invest their remaining funds as well as new savings and borrowings. A fresh collapse can then send them into deep depression.
Only investors aware that they are buying a fantasy will be comfortable with growth stocks. Idea people have fun with growth stocks. There is always a new idea that could grow into a world-beating company. Number people suffer from growth stocks. Number people do fancy calculations of sales, earnings, book value, return on capital, and growth rates to determine the likely price of a stock in five or 10 years. Number people are heartbroken when all their fancy calculations turn into losses.
Worker bees will have fun with micro cap stocks. These are companies too small to be included in the indexes or to be owned by the mutual funds. No analysts cover these companies. If you enjoy discovering stocks no one has ever heard of and are interested in working hard at finding and analyzing these companies, the financial rewards are high. You will not be able to toss out the names of your stocks at parties because no one will know what you are talking about. Patience is required because these things take time to be found by other investors and bid up in price. This is often a lonely but rewarding business.
Investors without patience or research skills may be tempted to buy micro cap mutual funds. Unfortunately, the micro cap mutual funds have all the problems of other mutual funds: they all buy the same stocks, get caught up in manias such as tech mania, tax you for gains that were not yours, siphon off fees, and focus on gathering assets and marketing rather than increasing your returns. And micro cap funds buy such large amounts of stock that they bid up the price of shares as they buy, then they depress the price as they sell. Micro cap mutual funds have many built-in resentments.
Are we talking personal growth or portfolio growth?
Stocks that collapse in price were once known as dogs and cats. Brokers started calling them value stocks and were able to peddle them to individuals and mutual fund managers. Unfortunately, value stocks are highly unstable. Many are troubled companies headed for bankruptcy. Others are turning around. In today’s markets, value stocks can quickly become overpriced.
Then value fund managers sell them to growth managers. Investors looking to value stocks for low volatility will not find it. Growth stocks are overpriced stocks that are hyped as having huge earnings potential. Growth investors are gullible sorts who believe a few years of fabulous growth will be repeated for decades. They are willing to pay any price for this dream.
The tech mania of 1999 was an extreme example of this magical thinking. Growth investors convinced themselves that untested Internet companies would take over the American economy in a few years. Tech mania has a long and sad history in stock investing. Tech mania generally ends badly. Railroad stocks got up a full head f steam and then jumped the track in the late 1800s. Electricity plays and auto stocks had huge booms and busts in the early 1900s. Long-term studies show that tech stocks do no better than the overall market. However, they are subject to periods of extreme volatility. Tech stocks, when the mania is on, double and triple in a few months. Then they lose 95 percent of their value in the crash. Tech stocks are for dreamers and speculators, not investors. People who do not mind losing a few thousand dollars for the potential of extreme wealth are comfortable with tech stocks. Investors with low self-esteem, who may throw good money after bad, should stay away from tech stocks and other growth stocks.
Discretionary income is the key
With an increase in positive cash flow, you can direct more toward your debt. The more debt you pay down, the less interest accumulates during the following week, month, or year. The less interest accumulates, the greater the amount of your next payment that gets applied to the balance, and so on.
By increasing your positive cash flow, you can ultimately increase your debt payments. Instead of being caught in a downward and negative spiral, you find yourself in a positive, upward spiral. There is a name for this “positive cash flow” that you need to increase in order to eliminate your debt. It’s called discretionary income.
While the term sounds complex, it’s simple when you stop and think about it. It’s the income that’s left after all your required bills have been paid; you choose how to spend it. To accelerate the process of getting out of debt, you ultimately have to increase the amount of discretionary income left at the end of the month.
Set a financial goal
To help you visualize the rewards of all your hard work, I want you to sit back, close your eyes for 60 seconds, and imagine a debt-free life. In fact, I want you to imagine the number-one thing that will change. Do it now, I’ll wait right here for you! Now, grab your Debt Journal and sum up that change in three or four words. Write it really big and circle it. This is your opportunity cost of failing to reduce your debt. By not getting your debts paid down, this is what you’re missing out on. Strive to keep this at the front of your mind!
Introduction to debt equity
Much of the complexity associated with debt for equity swaps comes from the need to comply with rules governing their accounting, taxation and implementation, both on the part of the company and its lenders. In addition, the shareholdings arising from such transactions can give rise to continuing compliance and reporting obligations for the lenders, particularly if they become major shareholders in a company. The impact of these matters must be fully considered at the time the restructuring options are being evaluated.
The following technical issues are considered:
- Accounting.
- Taxation.
- Legal and regulatory.
- Mechanics of implementation.
The focus is on considering these issues from a lenders’ point of view. However, matters addressed in this chapter vary considerably between countries. Moreover, treatments can at times conflict between jurisdictions. Therefore, it is critical that the readers familiarise themselves with their local accounting, taxation and legal frameworks affecting debt for equity swaps. Also, transactions involving a company with operations in more than one country, or a lender group involving banks from different jurisdictions, may need to comply with the laws and regulations in all the jurisdictions involved.
Professional Advice with Equity Score Report
The Moody’s Equity Score Report breaks down results by vintage and asset type, and further into terminated and nonterminated deals. This report lists each deal (with a nine-digit number as the Moody’s Equity Score Report Deal ID), and then lists the following information: the total cash return, dividend yield, previous dividend yield, cash-on-cash return, XIRR and payoff date (if applicable). Total cash return is the nondiscounted sum of all payments to equity from closing to the most recent payment date, divided by initial equity balance. Dividend yield is the most recent payment to equity, divided by initial equity balance, multiplied by the payment frequency. Nonpayments are treated as zero for dividend yield calculations. Cash-on-cash return is the nondiscounted sum of the equity payments over the previous year, divided by the initial equity balance. Deals with less than one year of equity payments do not have the cash-on-cash return calculated. XIRR is the internal rate of return for equity cash flows, adjusted for the timing of these payments. The Moody’s XIRR assumes equity is purchased at par, and that the equity has zero liquidation value. This last assumption is problematic, as it is highly doubtful that the collateral pool has zero value, and leads to large negative XIRRs for deals in which the equity holder has not yet been made whole.
The Equity Score Report shows investors how the equity of different deals is performing. Moody’s disguises the deal names, but investors still can use the report to look at trends in equity performance. For example, the investor can examine how many 2001 RESECs are currently paying double-digit dividends, or how many CBOs terminated without making whole equity holders.