Nimble, debt-free firms more likely to be around after Covid

Risks of Covid-19 to the corporate sector are on the rise, with the demise of SA’s largest non-food retailer, Edcon, a salutary lesson for those hoping to survive.

Highly leveraged firms that have amassed piles of debt are the most likely to feel the pain of the fallout now. At best, overextended companies risk losing out on the rebound and, at worst, may face a fight for survival.

Forbes summed up this problem well when it said few companies are able to resist the lure of leverage. Its investigation, which analysed 455 companies in the S&P 500 Index — excluding banks and cash-rich tech giants such as Apple, Amazon, Google and Microsoft — found on average businesses in the index nearly tripled their net debt over the past decade, adding about $2.5-trillion in leverage to their balance sheets. For every dollar of revenue growth over the past decade, the companies added almost a dollar of debt.

The Covid-19 slowdown has created corporate strain through a liquidity crisis — albeit mitigated to an extent by US Federal Reserve lending — and a solvency crisis, which has seen revenues of thousands of companies collapse in the lockdown.

What we saw during the recent Covid-19 market selloff, when many companies lost about 30% of their value, was that businesses with a poor return on assets yet a higher return on equity were sold off, as investors started to see through the financial engineering of boosting returns through leverage. Conversely, companies with a higher return on assets and lower debt were rerated at the expense of their overoptimised peers.

In other words, global markets rerated companies with more stable revenues and lower debt, and derated companies with less stable revenues and higher debt. However, as the eventual path out of the Covid-19 economic shock remains uncertain, it isn’t clear whether this rerating and derating have run their course, or when this will reverse.

With about $12-trillion of global bonds yielding negative interest rates, the global financial system faces another significant risk: the huge misallocation of capital.

This is because every costof-capital calculation, which is needed when pricing a major new project or development, starts off with a global bond, to which is added other risk premiums.

Simply put, if your starting point is -1% and you add 4%, it takes you to 3%. Add another 2% for uncertainty and it takes you to 5%.

Higher risk is simply not being adequately factored in.

In our view, the most resilient companies will, therefore, be those not pricing projects based on current negative rates, but those that are able to withstand shocks when risk is repriced to more realistic levels. Our assessment is that companies that are able to show greater resilience in the face of uncertainty will be those that avoid cheap and unmanageable debt, build strong balance sheets and ensure supply chains are more robust, with built-in redundancies to better withstand external shocks, volatility and uncertainty.

To achieve greater resilience, we need a social compact between government policies and business management to improve the resilience of companies, as well as of supply chains, to ensure resistance to global shocks. The importance of resilient companies, reliable supply chains and their role in building sustainable communities has never been greater.

THE BEST ADVICE IS TO BE IN A RELIABLE, ALL-TERRAIN VEHICLE RATHER THAN A FERRARI TO GET YOU TO YOUR DESTINATION SAFELY

In the current situation, where frailties in pre-existing global supply chains are horribly exposed, more onshoring of local companies and production is likely to become necessary. This, however, will not happen without the correct incentives in place, making it crucial that policymakers step up.

A World Economic Forum (WEF) report rightly holds that the current crisis is an opportunity to reset a system that has relied on outdated processes. Creating smart and nimble supply chains will be the key to building a global trade and investment network that’s capable of weathering future storms.

The WEF explains that when Chinese factories closed in the wake of Covid19, manufacturers struggled to pivot due to a lack of flexibility in their supplier base.

One likely consequence is that global firms will diversify their supply chains in future, instead of relying only on China. However, the WEF also highlights that policymakers will face pressure to make the right decisions.

The road ahead is full of potholes and steep curves. Portfolios need to be geared to withstand a range of conditions, and the best advice is to be in a reliable, allterrain vehicle such as a Gwagon (or Land Rover), rather than a Ferrari, to get you to your destination safely.