We can say two things about the next stock market crash. First, there will be one. Second, we can’t know for sure when it will happen.
I’m not one for making grand predictions. I focus on finding companies, with good long-term growth potential, attractive dividends and so on.
Having said that, I think there’s one big risk currently evident at both the macro and individual company levels. I reckon you can better prepare your stock portfolio for trouble by giving this risk due attention.
Global debt is ballooning
More than a decade after the last financial crisis and recession, the global economy appears fragile. It also appears dependent on the continuing support of central banks via low interest rates and unconventional monetary policy. The trouble is, global debt is ballooning as a result.
It hit a new all-time high of $253trn last year, according to the Institute of International Finance. The global debt-to-GDP ratio of 322% also surpassed the highest level on record.
Historically, waves of debt accumulation have had unhappy outcomes. And ominously, the World Bank has described the current binge as the biggest, fastest and broadest-based in the past 50 years. Debt is rising on every continent. And it’s rising in households, companies and governments.
A word from Warren Buffett
As far as companies are concerned, the International Monetary Fund has painted a scary picture in the event of an economic slowdown just half as severe as the last one. It calculates nearly 40% of total corporate debt in major economies would be owed by companies unable to cover their interest expenses with their earnings.
Borrowing money is so cheap that many companies have loaded their balance sheets with debt. In some cases, they’ve upped their borrowings simply to buy back their own shares and/or support otherwise unaffordable levels of shareholder dividends.
I think this is a case of what the great investor Warren Buffett calls “the institutional imperative”. He’s warned us never to underestimate “the tendency of executives to mindlessly imitate the behaviour of their peers, no matter how foolish it may be to do so”.
Buffett’s own company, Berkshire Hathaway, currently has more cash on its balance sheet than ever before.
Financial fitness
Back in the day, I was taught the first thing an investor should do is look at a company’s balance sheet. There was even a simple rule of thumb on ‘net gearing’ to help you judge a firm’s financial fitness.
A company’s net gearing is its net debt (total borrowings minus cash and equivalents) as a percentage of shareholders’ equity. You can readily find the relevant numbers for the calculation on the company’s balance sheet.
Net gearing of below 50% is generally prudent, 50% to 100% may be acceptable, and over 100% is into high-risk territory.
While not the be-all and end-all, checking the net gearing of the companies in your portfolio should give you a broad overview of the financial fitness of the businesses you own. And how they might fare in the event of an economic downturn.
In the coming days, I’m planning to revisit the balance sheets of many popular FTSE 100 stocks. I’ll be looking at net gearing, other indicators of strength and risk, as well as dividend sustainability. Look out for articles on the companies you own or are thinking of investing in!
