This past week, we’ve featured longtime PBRG friend Porter Stansberry’s views on the forces leading to the coming credit collapse—and how you can profit from it. Today, Porter explains how you can put the theory behind his big idea into practice (originally published November 10, 2016, in The Stansberry Digest).
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From Porter Stansberry, founder, Stansberry Research: Today, we continue on our credit-default cycle theme with an eye toward actual, real-time business examples.
So if you’ve grown weary of our macroeconomic explanations about Austrian economic theory or “negative multipliers,” don’t worry. What you’ll find below is the “nuts and bolts” of how you can put these theories into practice.
Before we begin, one word of warning. The examples I (Porter) give below may or may not be included in our initial version of “The Dirty Thirty” that we will publish in the first issue of Stansberry’s Big Trade next week.
I’m not trying to be coy. The Dirty Thirty is a market-based set of corporate targets. It’s a list of the 30 worst corporate credits that have the most equity value and the cheapest long-dated put options.
Naturally, that is going to change a little from month to month. The fundamentals of these companies probably won’t change much, if at all. But the market prices and equity values will. Thus our list will change, too.
Our core premise is the marginal utility of debt…
As companies take on excessive amounts of debt, sooner or later, their margins collapse and they begin spiraling toward bankruptcy. Why? Because few businesses actually have any real advantage in regard to access to capital. It’s never just one business that “levers up.” Instead, bankers visit every company in the sector. And, as production increases, profit margins always erode substantially.
Think about what happened to the onshore oil drillers over the past five years. As an industry, these companies borrowed $500 billion in the corporate bond market. And guess what? Production soared, which sent oil prices crashing. Now the sector has tons of debt… but much less ability to service it.
A little borrowed money, given to a few companies, would have greatly increased their profits. A lot of borrowed money, given to virtually every company in the sector, has seen profits almost completely wiped out. And that has happened in a lot of businesses, not just the oil patch.
A few easy examples…
Over the past 30 years, the car industry has seen tremendous competition and an explosion in debt, as carmakers had to finance big contributions to employee pension funds to support hundreds of thousands of retired workers. Those trends already bankrupted General Motors (GM) and Chrysler (FCAU). They will soon bankrupt Ford (F).
Since 1987, Ford has borrowed an additional $77 billion, taking total debt to a peak of around $145 billion. To put that in perspective, Ford had its best year ever in 2015, delivering a little more than 2.5 million cars and trucks. Thus, the company has been carrying almost $60,000 in debt per vehicle sold!
All of this capital and record volume hasn’t improved Ford’s profitability. Operating margins are half of what they were 30 years ago (5% versus 10%). And don’t forget, from 2006 to 2009, Ford was losing money on every car it sold. What has changed lately is a huge increase in demand via subprime auto finance. My bet is, as subprime auto financing shuts down because of rising default rates, Ford’s volume will collapse by 15%-20%, and it will begin losing money again. Sales fall, but debt burdens don’t change.
Here’s an example that will probably surprise you: Avon Products (AVP). Explain how ladies selling makeup door to door requires more than $2 billion in debt. Since 1998, Avon’s debt has increased almost 10 times, from $250 million to $2.2 billion. Meanwhile, operating margins have collapsed from 12% to less than 3%. You see, there’s this new thing called the internet. And it’s available 24/7 to buy anything you want from the comfort of your home.
Finally… it’s not only the oil firms that have gotten into too much debt. Debt largely financed the massive expansion of pipelines and other energy infrastructure over the past decade.
Want to buy a wind farm in France? Call Enbridge (ENB). It’s a big pipeline operator that is also building solar-energy projects and wind farms… with lots of borrowed capital. Debt has grown by more than 12 times over the last 20 years and now totals $31 billion. Over the same period, operating margins have shrunk from world class (20%) to pitiful (3%). Maybe someone should tell the board that wind farms aren’t as good a business as oil pipelines.
We are not necessarily trying to short these companies (via put options). They’re just simple examples of how often companies try to overcome competition (Ford), or disruptions to their business model (Avon), or get away from their core business with huge expansions to their debt loads (Enbridge). But as everyone probably knows, it’s a heck of a lot easier to make projections and take loans than it is to earn profits and pay back debt.
Spotting companies that are heading for credit downgrades and defaults is a lot like painting by numbers. You just look for who has borrowed a lot of money and then see if that’s working out for them. Usually, it isn’t.
One more example for good measure. Precision Drilling (PDS) is an onshore-oil field-services firm. If you need a hole drilled in the ground, you call these guys. To capture more business, Precision borrowed a ton of money. Debts have grown from $200 million to $1.6 billion over the last 15 years. But lots of other businesses saw the same opportunity… and borrowed money, too. Profit margins have fallen from 10% a decade ago into negative territory today. Precision is losing money with every hole it drills… and trying to make it up on volume. We wish them luck.
These are a few of the "microeconomic" examples of the macroeconomic themes I’ve been discussing…
They are real-world examples of how borrowing a lot of money rarely leads to prosperity.
Capitalizing on these problems is a lot different than investing in good businesses. With a good business, time is your friend. A capital-efficient company like Hershey (HSY) will simply compound your wealth by increasing its dividends every year as its business slowly grows and the economies of scale continue to deliver big benefits to owners.
Highly indebted companies, on the other hand, tend to tread water for a long time before drowning. At first, profits collapse. But companies can make adjustments and promises. Additional credit will continue to flow. Debts can be refinanced. But… as more time passes… and as margins continue to decline… sooner or later, real cash-flow problems will emerge.
In an instant, the entire sustainability of the business will come into question. Suddenly, the stock will collapse. Even if the company doesn’t outright default, it can begin a death spiral as it sells assets to repay its debts, eventually leaving nothing for shareholders.
It’s that moment where confidence is lost—like what happened to Hertz (HTZ) this week—that we’re aiming for in Stansberry’s Big Trade…
Yes, we can profit by trading around these positions as volatility ebbs and flows. That should earn us enough profits to begin investing with “house money” long before the crisis with corporate credits begins in earnest. But next year, we’ll see dozens of situations like Hertz. And in 2018, we’ll see hundreds. Even if we only "hit" on five or 10 of them, we’ll make huge profits overall thanks to the massive leverage available to us via put options and the extremely low price of those options right now. The defaults are coming. It’s only a matter of time.
Reeves’ Note: Porter’s hosting a live presentation on Wednesday, November 16, at 8 p.m. ET to tell you exactly what happens next in the credit crunch… and what you need to do to prepare. If you still haven’t reserved your spot yet, we urge you to do so now by clicking here.
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One small correction… On Friday, I (Porter) was in a hurry and didn’t do a great job of explaining what’s admittedly a complicated idea—about the effect that large government debts have on stimulating the economy. I wrote that various studies had found that government spending causes a negative-multiplier effect and reduces economic growth. What I meant was government deficit spending causes a negative-multiplier effect on economic growth in countries where debt-to-GDP is already more than 70%. I explained the negative-multiplier idea in far more detail and gave a complete list of original sources (if you like reading academic economic research) in the October 7 Digest. I regret making an already complicated idea more confusing, but the bottom line is the same: Borrowing too much doesn’t make individuals or entire economies rich. Research shows that cutting taxes (as Trump promises to do) is unlikely to deliver any lasting economic benefits if it leads to a corresponding increase in government debt. So can Trump cut taxes without adding to the deficit? No way, not when we’re already running huge annual deficits and so much of the government’s spending (around 70%) is for transfer payments and entitlements that are “mandatory” and not part of the discretionary budget. Nevertheless, I’m sure that for the next few months… or even a year or two… folks will hope that Trump will pull a rabbit out of his hat and bring back significant amounts of economic growth. Trust me, it won’t happen. The Republicans can’t make our $20 trillion in federal debt disappear. You can think of that gigantic problem as the Obama legacy. We’ll be paying for it for decades. |
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