This site uses cookies

To give you the best possible experience, the GAM website uses cookies. You can read full information of our cookie use here. Your privacy is important to us and we encourage you to read our privacy policy here.

OK
The disappearance of tangible equity in the US

21 August 2018

There is a strong rationale for considering tangible equity when assessing corporate balance sheets. For Western companies, particularly those in the US, the ‘safety net’ of tangible assets has noticeably shrunk in recent years while net debt has increased rapidly; GAM Investments' Ben Williams believes this development carries risks and seems unsustainable.

Corporate net debt in the US seems to be on an unsustainable trajectory; over the past five years net debt has risen by 76% while at the same time tangible equity has fallen by 40%. Notably, S&P non-financial tangible equity is now a mere 9.2% of tangible assets. This is either genius or foolhardy depending on the stage of the economic cycle.

Tangible equity matters

Tangible equity is the measure of a company’s capital, which is used to evaluate an institution’s ability to deal with potential losses. It is calculated as total shareholder equity minus disclosed intangibles. In good times one can arguably ignore the balance sheet. However when conditions deteriorate it is often the case that the balance sheet is the only thing that matters. In extremis, goodwill and other intangibles cannot be used to pay your creditors.

As an example, this year’s collapse of UK construction services company Carillion offers a glimpse as to why balance sheets sometimes do matter. The UK government has just completed a review on why the company went bust, but the simple fact is that for years it was being run without any tangible equity and therefore no safety net.

Many stock market investors, it seems, have moved on from looking at balance sheets, which in our view is a mistake. It is our belief that one of the drivers of stock returns has been how companies have managed their balance sheets, as well as how they have managed their underlying business.

Share buy-backs and M&A using borrowed funds have contributed to the “flow” which helps drive markets. While strong earnings have facilitated some of this flow, a major contribution has come from the balance sheet. This has been particularly noticeable in the West where companies, most notably in the US, have geared up their balance sheets over the past five years. Debt has increased and tangible equity has collapsed.

M&A premiums have led to the generation of large goodwill and intangible balances. Acquisitive companies have taken the opportunity to capitalise the value of “brands”, “licences” and “client relationships” as assets on their balance sheets, and consequently “goodwill” and other intangible assets of “uncertain” value have grown significantly. Scratch below the surface and the robustness of many balance sheets has deteriorated enormously.

We are not suggesting all intangibles are worthless. However, it is worth highlighting that perhaps the best brand company in the world, Apple, has only USD 2.3 billion of acquired intangibles on its books, plus a modest USD 5.7 billion in goodwill, which equates to just 2% of balance sheet assets. Similarly, Toyota has zero intangibles and Nike only USD 283 million in identifiable intangibles and USD 154 million in goodwill. In short, many top quality companies do not capitalise the value of intangibles on their balance sheet. This suggests to us that one should be wary of lesser companies sporting balance sheets awash with other intangibles.

Table 1 - Ben Williams
Source: Corporate balance sheets as of June 2018. For illustrative purposes only.

Past performance is not an indicator of future performance and current or future trends. The companies listed above were selected by the author to assist the reader in better understanding the themes presented. The companies included are not necessarily held by any portfolio and do not represent any recommendations by the author.


The chart below shows total shareholder equity by region broken down into tangible and intangible equity.

Chart 1: Shareholder's Equity composition

Chart 2
Source: Bloomberg: (From left to right: US, Japanese, Europe, UK and Pacific ex Japan equities) as of June 2018.

Past performance is not an indicator of future performance and current or future trends. The example above is being provided for illustrative purposes only. The example provided was selected to assist the reader in better understanding the various themes presented.

Chart 2: Shareholder's equity composition - common size

Shareholder's equity composition chart
Source: Bloomberg as of June 2018.

Past performance is not an indicator of future performance and current or future trends. The example above is being provided for illustrative purposes only. The example provided was selected to assist the reader in better understanding the various themes presented.


It is surprising to see how little tangible equity there is (left) in Western companies. We are dealing in aggregates and, while not all companies are the same, it is clear that US companies operate with far less tangible equity than other regions.

The table below shows the change in net debt by region over the past five years. The key standout is the US, where net debt has increased by 76%. Whether you believe, or not, that tangible equity is a useful metric in measuring balance sheet strength, we believe one cannot help but feel that the rate of growth in net debt in the US is alarming.

Table 2 - Ben Williams
Source: Bloomberg as of June 2018.

Past performance is not an indicator of future performance and current or future trends. The example above is being provided for illustrative purposes only. The example provided was selected to assist the reader in better understanding the various themes presented.


Pushing the limits

In 1977 Warren Buffett wrote a brilliant article in Fortune magazine entitled “How inflation swindles the equity investor”. Much of it remains relevant today, in our view, in particular the reminder that to raise return on equity (RoE) corporations would need at least one of the following: (1) an increase in turnover, ie in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes; (5) wider operating margin on sales. That is it. In our view, there simply are no other ways to increase RoE.

Back in 1977 Buffett felt that, in his words, “American business already has fired many, if not most, of the leverage bullets once available to it”. He adds “in the 20 years ending in 1975, stockholders’ equity as a percentage of total assets declined for the Fortune 500 from 63% to just under 50%. In other words, each dollar of equity capital now is leveraged much more heavily than it used to be.”

We can perhaps forgive him given that interest rates are far lower than they were in 1977, however, 41 years later American businesses have continued firing their leverage bullets. With tangible equity a mere sliver of assets and 76% growth in net debt over five years, we doubt this trend can be sustained.

Going forward we would urge investors to keep a keen eye on corporate leverage. In our view, a shift from equity to debt financing is a shift from permanent capital towards capital that requires periodic re-financing. Assuming credit will be readily available, at the right price, has from time to time proven costly to investors. Simply put, we believe this capital structure is inherently more risky.

The divergence in balance sheets, both within countries and across regions, should offer significant alpha opportunities to investors in the coming years, whereas it is worth noting that index funds, by definition, will have to hold both the good and the bad.

Moreover, it seems the most attractive opportunities, or the least risk, most likely lie in the companies and markets that are yet to play the leverage card.

 
Important legal information
 
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is not an indicator of future performance and current or future trends.
Scroll to top