Investor Essentials Daily

The Number of Wounded Companies Is Important for This Reason

May 8, 2023

A history lesson can teach us about recessions.

Legendary French general Napoleon Bonaparte invaded Egypt at the turn of the 19th century. During this battle, he was forced to make some tough decisions.

With excessive heat, scarce food, and plague tearing through the French army, Napoleon and the doctors decided to use their limited supplies on those soldiers they could save. Anyone who was too sick went to the back of the line of treatment.

Napoleon still lost the war, but this was the first example of triage being used in medicine.

In the investing world, a company’s credit risk is treated the same way. The worse off the patient – i.e., the company – the more leery investors get and the more likely they are to pull their money to put it somewhere healthier.

When companies end up with imminent credit risk, the investors leave them for dead.

And when enough companies go bankrupt, you get a recession.

So if you want to understand how high the risk of a recession is, the first question to answer is… how many companies are graded as “high risk?”

So today, let’s take a deeper look at how much risk U.S. companies have today. That can help us understand how likely a recession is, and how bad it might be.

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Is there going to be a corporate bloodbath?

Along with looking at Credit Cash Flow Prime (“CCFP”) analysis, there are a few other ways we gauge corporate health. One is looking at how much cash companies have on hand relative to near-term obligations.

Right now, the Federal Reserve is trying to push more companies into the “high risk” category. It’s raising interest rates to make it harder to borrow more money and to refinance. It’s trying to slow down the economy.

But if companies have cash on hand to meet their debt maturities, the Fed’s efforts will cool down the economy without doing serious damage.

We can look at how many companies have more cash than they have debt coming due in each of the next three years to see what kind of shape they’re in.

Take a look.

From 2019 to 2021, many companies scrambled to build enough cash to handle their near-term obligations. They didn’t want a cash crunch. In 2020, nine out of every 10 S&P 500 Index companies had more cash on hand than debt coming due in the next 12 months.

For most of the past 15 years, roughly three out of every four companies carried more cash on hand than they had debt maturities. The number of companies that had more cash than debt maturing in the next three years tended to peak at roughly seven out of every 10.

Right now, companies aren’t holding as much cash as they were at pandemic highs, but levels are still above average.

Almost four out of every five companies have more cash than debt for the next year. And those with enough cash for the next three years are near those normal peak levels.

That’s great news. It means that the economy isn’t about to get slammed with very sick corporate patients.

The Fed’s actions the past year or so have definitely hurt a lot of weaker companies. Some companies won’t be able to refinance their debts with high interest rates and slowing demand.

But thanks to how healthy corporate balance sheets are as a whole, those sick corporations are going to be fewer and farther between than they normally would be as the Fed cranks up the rates.

And that’s why even though we’ve been saying a recession for some time is likely looming in late 2023 or early 2024, we’ve also been saying for just as long that any recession is likely to be mild.

With this choppy market, there will be buying opportunities. Take advantage of companies that will be able to weather the storm.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

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