Lean, Mean Fighting Machines Emerge From Debt Diet

Just like a raw marine recruit will leave Paris Island as a lean, mean, fighting machine, companies that engaged in the debt diet are emerging far stronger than when they entered. The Debt Diet With credit default swap spreads back to levels not seen since early 2018, it is almost hard to remember that at the start of the year so many investors were worried about an impending blow-up in credit markets -- particularly the BBB segment. We felt that concern about credit was wrong and called 2019 the year of the debt diet. I was lucky enough to be able to present this view on CNBC at the start of the year and then do a follow up in April as the debt diet was clearly working. The premise was simple: Companies would act to reduce their risk of downgrade, which would be very good for credit spreads. Stocks would benefit mildly because stock prices were under pressure due to credit concerns. We had a number of companies that fell into the debt-diet camp for a variety of reasons. These names range from Comcast and IBM due to M&A activity, to Verizon which had largely lived up to its promises to deleverage, to AT&T which was facing pressure, to Anheuser-Busch InBev and Newell Brands which had possibly waited too long, to General Electric . Vodafone is another name that comes up in conversations as well as several in the energy and mining sectors. There are a lot of companies that needed the debt diet and they participated in the debt diet in a variety of ways. Some companies, such as BUD and AT&T, did large bond deals, that created little or no new debt, but extended their maturities, reducing near-term pressure. Virtually all of the companies either tendered for bonds, bought them in the open market, or simply paid off maturing debt out of free cash flow. Basically, free cash flow was diverted from directly benefiting shareholders, to supporting the credit. Emerging From the Debt Diet Free cash flow will now be able to be diverted back to shareholders, directly through increased dividends and/or renewed and increased share buyback programs. AT&T's earnings call said it all. The company deleveraged more quickly than many expected. The CEO said to Fully expect we'll be buying back stock this year. However, investors haven't fully digested: How quickly the powerful cash flow generators can deleverage. What the ability to stop diverting so much free cash flow to additional debt service will mean for equities. The companies that succeeded in going through the debt diet are going to emerge with a greater ability to reward shareholders, without putting the debt at risk. Low Yields Are Helping Too While companies implemented healthy strategies, the markets have helped as well. Bloomberg Corporate Bond Index Average Yield While it seems mundane, if not childish, to talk about interest coverage, as talking about debt to EBITDA makes one sound much more intelligent, it is a driving factor in free cash flow. It was reasonable for companies (and investors) to become concerned about what the cost of debt would be going forward as it seemed we were about to get the long-awaited spike in bond yields. An extremely dovish Fed has pushed corporate bond yields much lower as Treasury yields have declined, and corporate bond spreads have tightened. The average corporate bond yield rose almost 1.25% over the course of a year and has dropped by 1.25% in six months. The decline in bond yields is a big reason why companies can emerge from the debt diet faster than many expected. The other reason, I think, is that many underestimated how quickly companies could resolve the perception of debt issues. What to Do? Scour the universe for companies that have diverted free cash flow from equities to bonds. I've mentioned a few names here as potential candidates, but there are many more, including some attractive high-yield companies. I'd also look at companies in the energy and commodities industry where possibly irrational credit fears still seem to linger after the ugliness of 2015 and 2016. Estimate how soon they will be able to reverse that diversion of free cash flow: Anything within six months should be attractive because now that AT&T came out so aggressively on their earnings call, analysts will be starting to think about this. Basically, the catalyst for equities is now out of the bag, it is just a matter of finding companies with that catalyst before everyone catches on that the debt diet was successful and equity holders will be rewarded. Build a portfolio, or at least overweight the stocks of those companies. While the big moves in credit spreads are over, there is no reason to think these credits will underperform even as they shift back to spending more free cash flow on equities, because they are in better shape than when they started the debt diet.

Lean, Mean Fighting Machines Emerge From Debt Diet

The catalyst for equities is now out of the bag, it is just a matter of finding companies with that catalyst before everyone catches on.

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