All posts by Pat McKeough

Why Debt-to-Market-Cap matters more than Debt-to-Equity

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Understanding the Importance of the Debt-to-Market-Cap Ratio in Stock Analysis

Image courtesy TSINetwork.ca

When evaluating stocks, it’s crucial to assess their resilience during economic downturns and their potential for future prosperity. While the commonly used debt/equity ratio offers insights into a company’s financial leverage, it fails to capture certain nuances. In this article, we explore the significance of the debt-to-market-cap ratio in stock analysis and why it surpasses the debt/equity ratio.

By understanding the intricacies of this approach, investors can make more informed decisions and increase their chances of identifying companies poised for long-term success.

I was recently asked why I use debt-to-market-cap in my analyses, which is different from the debt/equity ratio seen in most other reports. My answer is two-fold. In analyzing a stock, you need to form an idea of how much it would get hurt in a recession. To put it another way, how likely it is to survive a business slump and go on to prosper when good times return? To do that, you need to look at a number of factors. These include the interest rate on its debt, how sensitive it is to the economic cycle, its pluses and minuses in relation to competitors, its vulnerability to adverse legal and regulatory decisions, its credit history and current credit rating … and so on.

Analyzing Debt-to-Equity Ratio

Many successful investors start by looking at the debt/equity ratio. This ratio comes in several variations, but the basic idea is that you measure a company’s financial leverage by comparing its debt with its shareholders’ equity. You assume an attractive company can earn a higher return on its total capital than the interest rate it pays on the debt portion of its capital. If so, the excess goes to shareholders’ equity, raising the total return to shareholders.

But leverage works both ways. If the total return falls short of the interest costs, the difference comes out of shareholders’ equity. When a company loses money, it still has to pay the interest and one day settle the debt. Generally, it does so by dipping into shareholders’ equity. In extreme cases, losses wipe out shareholders’ equity, and the stock becomes worthless. Then bondholders and lenders take over the assets to try to get back their investment. A high ratio of debt to equity increases the risk that the company (that is, the shareholders’ equity in the company) won’t survive a business slump.

However, this ratio can mislead because it compares a hard number with a soft one. Debt is usually a hard number. Bonds and other loans generally come with fixed interest rates, fixed terms of repayment and so on. Equity numbers are softer or ‘‘fuzzier.’’ They mostly reflect asset values as they appear on the balance sheet (minus debt, of course). But the balance-sheet figures may be misleading. They may be too high, if the company’s assets have shrunk in value since the company acquired them (that is, lost more value than the company’s accounting shows). In that case, the company may need to correct its balance sheet figures by cutting them or “taking a writedown.”

Or the equity value may be too low if the company’s assets have gained value since the company acquired them. This can happen with real estate, patents and other assets (which we refer to as “hidden assets”).Much of a company’s real value may rest in its “goodwill” — its brands, or the reputation and relationship it has built with customers over the years. This value would only appear on the balance sheet if it was bought rather than built up by the company’s operations.

Analyzing Debt-to-Market-Cap

Efficient market theory also leads us to favour debt-to-market-cap over debt-to-equity. This theory says that it’s impossible to beat the market, because the market is efficient and eventually reflects all information, good or bad. This idea had a lot to do with the creation of index funds. Market cap — the value of all shares the company has outstanding — benefits from the “wisdom of crowds.” Continue Reading…

Investing in Emerging Markets: Capitalizing on the Changing Global Export Landscape

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When considering investing in emerging markets, explore opportunities in the rise of emerging economies, exports, and shifting trade patterns

BRICS countries/Deposit Photos

Global trade has undergone a remarkable transformation over the past four decades, with its share in the global economy increasing from 36% to 57% by 2022. This surge in international trade has created opportunities for investing in emerging markets, which have become pivotal players in the ever-changing global trade landscape. Notably, China experienced a remarkable ascent, transitioning from a mid-size player to the world’s largest exporter within a mere two decades. Alongside China, other emerging economies, like Mexico, exhibited impressive growth, propelling them to the top echelons of global exporters.

In fact, Mexico is now among the top 10 exporters and a number of smaller emerging economies are growing their exports rapidly.

China still Dominates Global Exports

Although it has slowed lately, China remains the largest exporting country in the world. It delivered goods worth $3.6 trillion to global customers in 2022, or 16% of all global exports. This was roughly the same value of exports from the second and third-ranked U.S. and Germany combined.

Fellow Asian countries received almost half of Chinese exports while European and North American customers both imported 20% of the total. The largest single-country customers for Chinese goods are the U.S. (16%), Japan (5%), Germany (3%), Netherlands (3%), South Korea (5%), Vietnam (4%), and India (3%).

Chinese exports grew rapidly in the years after its entry into the World Trade Organization in 2001. For the decade after 2001, exports increased by 20% per year and contributed almost 30% of the Chinese economy for that decade.

However, growth in Chinese exports has slowed down over the past decade to around 5% per year. Also, when expressed as a portion of GDP, the importance of exports began dropping — averaging 20% over the past decade, down from over 30% in the previous decade. Continue Reading…

Why Canadian Investors should Include U.S. Stocks in their Portfolios

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U.S. stocks can provide Canadian investors with all the foreign exposure they need

I’ve been advising Canadian investors to include U.S. stocks in their portfolios for more than 30 years. I continue to recommend them today. The U.S. stock market offers the widest variety and highest investment grade of companies to invest in of any country in the world. It also offers a wider selection of growth opportunities for those companies to pursue, in North America and around the world.

For our portfolio management clients, our general preference is to invest one quarter to one third of their holdings in U.S. stocks and the remainder in Canadian stocks.

Many major financial institutions recommend investing in North America. Some also recommend investing outside North America, especially in developing nations. They say that countries outside North America also offer great opportunities, and they may be right in some cases. They note that foreign investing offers an additional chance for diversification. This may be true, but we see it as irrelevant. Our view is that North America offers all the diversification that you really need.

Many promoters of emerging-market investing are also motivated at least in part by a conflict of interest.

By offering imported investments in their home market, they can earn higher profit margins than they get with domestic investments alone. That is, they make more money by promoting foreign investments. Investors may not make any more money, but they undoubtedly face more risk.

We have occasionally offered favourable advice about a handful of high-quality foreign stocks in the past few decades, while mentioning the added risk. But we’ve stressed our view that the U.S. and Canadian markets provide all the investment opportunities that you need to succeed as an investor.

Of course, the Canadian market offers opportunities that beat those available in the U.S.: in bank stocks, in the Resources & Commodities sector, and in specialists like CAE Inc. But Canada has nothing to compare with, say, Alphabet, Microsoft, McDonald’s and any number of other household names.

Neither too hot nor too cold

Some investors say they agree with our view on U.S. stocks in principle, but they disagree with our timing. They think the U.S. dollar is just too high at present levels: too hot, you might say. These folks seem to think that the natural foreign exchange rate between the U.S. and Canadian dollars should be around parity.

As of late 2023, the U.S. dollar has traded at around one-third higher than the Canadian dollar. Way above parity! In fact, the U.S.-Canada exchange rate has not been anywhere near parity in the past decade.

The U.S. dollar has mostly stayed between $1.20 Cdn. and $1.46 Cdn. since the start of 2015. It’s now around the middle of that 8-year range.

Since 1971, the U.S. dollar has stayed between $0.94 Cdn. and $1.60 Cdn. It’s now around the middle of that 52-year range.

Timing is worth a look. But if you make it the deciding factor in your investment decisions, it’s apt to cost you money, in the long run if not in the short.

“Has-been” U.S. dollar has a long life ahead

A lot of foreign governments share the view that the U.S. dollar is overvalued.

In March 2023, in a meeting in New Delhi, the representative from Russia revealed that his country is spearheading the development of a new currency. It is to be used for cross-border trade by the BRICS countries: Brazil, Russia, India, China, and South Africa. (Potential recruits include Iran, Syria and North Korea.)

I put this ambition on a par with the claims of cryptocurrency promoters. Some of them still predict that cryptocurrencies will take the place of the U.S. dollar. Continue Reading…

The Thucydides Trap and the Challenges facing China’s Rise

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Examining the Thucydides Trap including factors impacting China’s economic and geopolitical growth

Shanghai Lujiazui civic landscape: Deposit Photos

Thucydides, a fourth-century BC Athenian historian and general, wrote a book about the Peloponnesian War, a conflict between Athens and Sparta. He concluded that the war was inevitable due to the growth of Athenian power and the fear it caused in Sparta. This idea, the Thucydides Trap, has been generalized to suggest that when a rising power challenges a dominant power, war becomes unavoidable.

The concept of the “Thucydides Trap” re-emerged in recent years, with some authors suggesting that the U.S. and China were likely to go to war based on Thucydides’ observations. However, comparing the economic power of China and the U.S. solely based on the size and growth rate of their GDPs can be misleading. China’s larger population should be taken into account, and when considering per-capita GDP, the U.S. still surpasses China.

The export boom in Asia started in the 1960s, led by Japan, and was followed by Taiwan, South Korea, and China. Each country developed its own export capabilities. However, China, despite its late start, has faced challenges in reaching the high-end market and relies on importing high-end components. On the other hand, Japan, Korea, and Taiwan excel in high-value manufacturing goods, such as advanced computer chips.

Massive inequality and limited consumption

China’s focus on expanding its workforce and factory output, rather than raising worker incomes, has contributed to its growth but has also led to massive inequality and limited consumption. The Chinese approach contrasts with the Western emphasis on using technology to raise productivity and wages. Additionally, China’s reliance on low-cost unskilled labor and its demographic challenges, resulting from the one-child policy, pose long-term problems for the country.

Russia’s war on Ukraine is not a clear example of a rising power challenging the U.S. and NATO. Russia has been a declining power for decades and has used outdated weapons in the conflict. The beating Russia has faced in Ukraine has surprised many and may have disappointed Chinese leader Xi Jinping, who may have hoped that Russia could distract the U.S. and NATO while China pursues its own long-term plans. After all, Russia has carried out some successful invasions in the past couple of decades, even if they haven’t recovered much of the lost Soviet Empire. But China itself hasn’t been in a war of any consequence since its 1979 border clash with Vietnam.

I.P. Theft

The U.S. announcement of broad new limits on sales of semiconductor technology to China has been viewed by some as a war-like gesture. However, China’s technological gains have often involved theft of intellectual property, according to foreign firms and individuals who have worked there and invested their own money.

They say that enforcing intellectual property rights in China is difficult for foreigners due to local judicial protectionism, difficulties in obtaining evidence, small damage awards, and a perceived bias against foreign firms.

China also forces foreign joint-venture operators to share their designs and patents with local partners, who may then go off and sell copies elsewhere in China or Asia. Many accept the demand, just to get access to the vast Chinese market.

More ambitious Chinese businesses may simply buy a copy of a competitor’s product and reverse-engineer it if that’s all it takes: just pirate the technology, in other words. In The End of the World is Just the Beginning, however, Peter Zeihan wrote,

“Or, if we’re being brutally honest, to successfully reverse-engineer the products of others: Don’t get me wrong, I don’t feel great when I see a new story about some Chinese spy successfully funneling American military technology to Beijing. But please keep it in perspective. China didn’t figure out how to make a ball-point pen without imported components till 2017. The idea that China can get a set of blueprints and suddenly be able to cobble together a stealth bomber or advanced missile system is a bit of a scream.”

Demographics is a key negative for China

China’s demographic situation is a significant long-term problem. The one-child policy and forced migration from the interior to the coast have resulted in an aging workforce and a shrinking labour pool. As retirees increase, the government will face challenges in supporting them with reduced tax revenue and a smaller labour force.

The key indicator of future population is the number of children the average woman has in her lifetime. The “replacement number” that keeps population stable is 2.1 children. The UN estimates that China’s rate dropped to 1.16 in 2021 from just under 3.0 in the early 1980s, and 2.5 as recently as 1990. After decades of government family-size control, the new legalization of larger families has not yet caught on. Continue Reading…

Artificial intelligence is evolving in different ways – how can you best profit?

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While Get Rich Quick publishers use AI for email advertising, investors combat their spam with AI-based anti-spam programs. Meanwhile, what’s the best way to profit from AI with less risk?

Image courtesy Pexels/ThisIsEngineering

AI continues to make gains, mostly in communications. (In contrast, early adopters are still waiting for a licensed, insurable, road-worthy self-driving car.) You also hear a lot about AI-related start-ups. Most seem aimed at improving existing devices and/or cutting business costs. Many have highly specific goals.

Meanwhile, AI will keep attracting investment interest.

Here’s how AI has changed one industry

As you’ve probably noticed, a boom is underway in the investment-newsletter publishing business, at least in its “GRQ” segment. (GRQ is an acronym for Get Rich Quick.)

GRQ publishers sell newsletters and related products to subscribers. Their expertise is in newsletter marketing, not investing. Many publish numerous newsletters that may offer conflicting advice. When one publication puts out a stream of bad recommendations that drive off too many customers, the publishers change the publication’s name and/or investment specialty. That way, they always have one or more fresh titles that still have customer appeal and can operate at a profit.

GRQ publishing has been around for many decades, if not centuries. But it really went into high gear in the early 2000s. That’s when email began to replace postal mail as the main carrier for newsletter advertising, and costs began to plummet.

In the days of postal mail advertising, it cost a publisher perhaps $1 per “name” to offer a newsletter subscription to prospective customers. Publishers had to create, print and mail elaborate mailing pieces. They had to rent prospect names from direct competitors, or from other publishers in the same or related fields.

Compared to the costs of paper/postal mailings a decade or two ago, today’s costs of email advertising are close to negligible. Now publishers spend heavily in other areas: direct marketing consultants, specialized writers of advertising copy for email marketing, and so on.

Some newsletter publishers seem to be using AI to help them create email ads in ever larger numbers, to send to investors who never asked for them: spam, in other words. Continue Reading…