Jan. 19, 2022

Prof. McGolrick's View Of Today's Corporate Leverage.

The year was 1972, and I was studying at the New York Institute of Finance. Preparing for a career in finance.

My principal Professor was Charles McGolrick. McGolrick was one of the colorful characters who filled Wall Street in those days. As a young man, he had seen the destruction of the Great Stock Market Crash of 1929 and the ensuing depression.

I was fortunate in those days to meet several survivors of the Great Crash, but Professor McGolrick was the most verbal of the bunch. To a man, all of these Wall Street Veterans had a visceral reaction to one thing: leverage.

It was a gut-level loathing of companies and individuals who got in “over their heads” by borrowing too much. To this generation, it was the excessive leverage that was the chief cause of the depression.

They would spend hours regaling us with stories of those who had built their castles on mountains of debt, only to become worthless wretches when things went south.

Now McGolricks classes were centered on Securities Analysis, and in looking at any company the first thing he would do is turn to the back of the Annual Report and review the Balance Sheet. Ignore all that fluff in the front, it's just marketing, he would say. The meat and potatoes are back here with the numbers.

And the very first number we would look at is, you guessed it, the company's debt. Too much debt would be the end of any further analysis by McGolrick. A company should have less than half its total capitalization as debt. Preferably MUCH less.

It's an exercise I like to continue up to today.

So yesterday, I got our financial reports on some of the market leaders, just to see how their “debt picture” looks.

You see, I've been curious about the reason why the high fliers in the market seemed to be so interest-rate sensitive. Every time we see indications of rising interest rates, as we did yesterday when bonds floated up to higher yields. We're also seeing some of the market-leading stocks take a dive. Just like we saw yesterday.

And I have to tell you I was surprised at how the management of some of the nation's largest companies have "leveraged up" their balance sheets.

Now two of the big five have managed to hold their borrowings under control. Both Alphabet Google and Facebook Meta. Would meet Professor McGolrick's criteria, with debt well below equity. They both pass the test.

But the rest, they're in trouble. We begin with Microsoft. This company is pretty consistent, in that it's always carried a fair amount of debt.

But the company that really surprised me was Apple Computer. If memory serves, up until recently Apple had virtually no long-term debt.

Well, that's changed big time. As CEO Tim Cooke, has become a real devotee of stock buybacks. Essentially converting the companies equity into debt.

That might be fine when interest rates are at historic low levels, and debt costs very little. But that's changing now, and with 4 times more debt than equity, and interest rates rising, I don't think it will be long before Mr. Cook and Apple begin to feel the heat.

Next comes Amazon. Again a company that has always carried a lot of debt. But they're doing something different right now, that I believe deserves special attention.

Amazon carries very little long-term debt. Only about one-third the level of their equity. This would be good news. Except that they carry nearly $200 billion in various forms of short-term debt.

Now I understand that this is because they have a tremendous amount of inventory to finance, and as any retailer, this could be the reason.

Still, this is a tremendous amount of overall leverage and has Amazon's overall debt at twice their equity.

Well, it's been nearly a hundred years since a young Charlie McGolrick entered Wall Street. Another roaring 20s, where markets are hot. And companies have divided themselves into two groups.

One the old-fashioned kind, like somewhat surprisingly Alphabet- Google, and Facebook- Meta, have elected to raise capital by selling ownership in their company. Common Stock, which has no payments due, or maturity deadlines.

The others have chosen the more aggressive road. They've borrowed most of their capital. Something which requires timely interest payments, and ultimately must be paid back in full. This leaves more for management and more for what few shareholders remain.

But in that great financial crisis of a century ago, it was these companies that most often did not survive. Just like Professor McGolrick called it.