Isranomics

With interest rates rising, companies with low debt preparing to reap rewards

by | Nov 21, 2022 | Portfolio Management | 0 comments

Warren Buffett once famously said, “Only when the tide goes out do you discover who’s been swimming naked.” In other words, one should not judge companies and investors based on their track record during bull markets. The true nature of success becomes evident when results continue to be produced in times of crisis. And now that interest rates are rising to levels not seen in the last ten years, the degree of leverage in the period of growth that was frequently supported by almost free borrowed capital is becoming apparent.

A corporation with a strong cash balance and no debt that is listed on the Tel Aviv Stock Exchange is extremely uncommon to find. This would have been fine if the environment of cheap credit was still present as it was a case only twelve months ago. However, things changed dramatically this year after central banks all over the world started hiking interest rates as a result of the high inflation. Therefore, from the companies’ perspective having a low or no debt became particularly relevant.

The increase in interest rate to a decade high has already had an impact on the Israeli property market as mortgage applications started declining after reaching a peak of 13.4 billion shekels in March. If the rate rise continues at the same pace, this will be reflected in sales as well, which in turn will have a negative impact on traditionally heavily indebted construction companies. In fact, this has already been reflected in their valuations as property segment of the Israeli stock market has been one of the most affected this year.

When credit is accessible and affordable, taking out loans and growing financial leverage for acquisitions and business expansion are of little concern to markets, but they quickly turn into a burden when circumstances change.

Nevertheless, despite the rising cost of finance and accompanying worries about firms’ ability to meet their obligations related to debt repayments, there are also companies that make high enough returns for investors without accumulating high levels of debt on their balance sheets.

Some of the most successful and well-known businesspeople in Israel, include Moshe Mamrod, the controlling shareholder of the air conditioning and energy company Tadiran, Rami Levy, the owner of the food retail chain bearing his name and the airline and travel company Israir, Yaakov Luxenburg, the controlling shareholder of Lapidot Capital, which invests in real estate, infrastructure, and communications, Yishai Davidi, the head of Fimi, the biggest investment fund in Israel, The Cohen Chazon Fund, and others, are known in the local capital market as those who are reluctant to use high leverage.

The reason to have low or no debt is pretty self-explanatory. As borrowing rates rise, managers of indebted companies begin to frantically look for solutions. An increase in the cost of borrowing would normally lead to an increase in bond yields, which in return increases the price of managing the existing debt load. In addition, when this happens, banks begin to demand increased security. The ability to run the business and deal with an economic crisis is weakened as a consequence, which leads to a potential loss of control in managing the entity. This is precisely what happened to Teva under the leadership of its former CEO, Eretz Vigudman, who went on a debt-financed acquisition binge. As a result, in order to service the company’s debt, a new CEO was appointed who was forced to make hard decisions, such as selling factories and laying off people. It must be noted that all of this occurred at a time when credit was readily available and inexpensive.

Rami Levi, who seems to be wary of taking on debt, can be found on the other end of the spectrum when it comes to managing borrowed funds. It is easy to see that the total long-term debt of the business he controls is less than 0.3% of the whole balance sheet value. Although it is fairly simple for a supermarket chain to incur debt because its cashflow is generated from food sales, Rami Levi considers such a situation to be risky. In fact, large food chains in Israel (Clubmarket and Mega) have collapsed over the years when they racked up significant debts and were unable to make the payments necessary for their return.

Therefore, when it comes to investing in the stock market, it is essential to look at the financial side of the firms, and especially at the level of debt accrued on their balance sheets.

Only time will tell how much the indebted companies will be damaged by higher interest rates, and which of them will fail to service debt and reach settlements with banks and bondholders. What is certain is that if and when this happens to companies with financial strength, an opportunity to purchase good enterprises at a reasonable price will exist, as in prior crises, and investors in such enterprises are likely to reap rewards in the long run.

*Disclaimer: Data, information, opinions, forecasts in this article are the opinions of the writer and should not be taken as financial advice. The information is provided as a service to the reader.

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