Highly leveraged companies with a proven business model would benefit from an economic recovery
Investing in highly leveraged companies is viewed as more risky vis-à-vis debt-free firms, and that’s because the former are characterised by high interest costs as well as the need to pay careful attention to their cash flows and coverage ratios. And any fall in profitability could impact the ability of highly indebted companies to meet their interest payments along with debt servicing capabilities, which in turn could impact their credit rating.
It’s no surprise that companies with a weak financial position are avoided by investors during an economic downturn, as any decline in operational profitability level may result in lower net profit and a sharp fall in the stock price. However, with interest rates having peaked and the economy expected to gradually recover over the next few quarters, investment in such companies could be considered.
The recently elected BJP-led government has taken several steps to bring the economy on a high-growth trajectory. Apart from that, the macro-economic indicators are showing signs of improvement; inflation is on the decline and the manufacturing PMI indicates rising confidence of this sector. Further, the new orders sub-index soared to its highest level since February 2013, and exports are buoyant, which has helped to contain the current account deficit.
The monsoon deficit, too, has shown signs of narrowing and it has helped to revive investor sentiment. However, emerging markets are currently witnessing high volatility due to the ongoing problems; in Iraq as well as Russia and Ukraine along with the fighting between Israel and Palestine. The strong second quarter growth in the US has reignited fears of rising interest rates in the world’s largest economy, which in turn could led to outflows from emerging markets but the steady improvement in local macro factors has made us better prepared.
Meanwhile, the Eurozone is still struggling with near-zero growth rates, with Italy, the third-largest economy in this region, has entered into a recession with two consecutive quarters of contraction. In addition, Germany’s industrial factory orders fell for a second consecutive month confirming waning growth in the Eurozone’s strongest economy.
Nevertheless, the recently announced stimulus measures of the European Central Bank (ECB), the TLTRO programme, is expected to grant more than 700 billion of four-year loans to banks at fixed rate of 0.25 per cent. The above measure will encourage the region’s banks to lend to households and private enterprises, which will boost credit for the real economy and ensure adequate cash in the financial system. The first round of disbursement is expected to happen over the next one month and it is also expected to result in fresh liquidity for emerging markets like India.
Implications for India Inc
The consensus amongst market analysts is that interest rates have peaked and are expected to start falling from the first quarter of calendar year 2015. The RBI, however, in its recent monetary policy maintained its view on interest rates but raised an alarm about the deteriorating trend of the global economy, which can result in fund outflows from emerging markets. In addition, the central bank is determined to curb inflation and maintained its target for this parameter at 8 per cent by January 2015 and 6 per cent by January 2016.
There are many companies with strong business models, proven capabilities, and strong asset base, but are currently struggling with high debts, resulting in stressed cash flows and lower profitability. Many of these companies are leaders in their respective fields and have a proven history of long-term wealth creation for their shareholders. Many of these companies had taken on debt to either build huge capacities during the economic downturn or to fund large acquisitions at the peak of the economic cycle.
However, as the economy recovers and interest rates start falling, these companies are expected to show an improved operational performance as well as a reduction in interest costs, which would help them to boost their profitability. It’s quite possible that as the economy recovery becomes pronounced, these erstwhile high-debt stocks could be tomorrow’s multi-baggers.
Investorsmusthavealong-termhorizontoreap the full benefits from such investments.
This article was originally published in Business India Magazine.
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Disclaimer: The views expressed in this article are personal and the author is not responsible in any manner for the use which might be made of the above information. None of the contents make any recommendation to buy, sell or hold any security and should not be construed as offering investment advice.