Challenges of a Post-Peak World

Fears that profit margins are about as good as they can get for domestic companies has fueled some of the recent selling pressure on Wall Street. Investors appear to be asking if the top is in on profitability, what will drive growth going forward? We have been banging that drum for a while and welcome those who are just now contemplating the threat posed by higher input costs. 
 
But despite the concern starting to capture the attention of investors, we believe the potential for damage is still being underestimated.  That’s because margins may be reaching an inflection point at a time when corporate debt loads are hitting historic highs. As the chart below shows, the ratio of corporate debt to revenue is nearing levels last seen during the financial crisis.
 
U.S. Corporate Debt as a % of Revenue
Heartland Advisors U.S. Corporate Debt as a Percent of Revenue Chart
Source: Cornerstone Macro, LP, 1Q 1970 to 2Q 2018
Gray bars in chart represent recessionary periods: December 1969 to November 1970, November 1973 to March 1975, January 1980 to July 1980, July 1981 to November 1982, July 1990 to March 1991, March 2001 to November 2001, December 2007 to June 2009
Past performance does not guarantee future results.
 
If, as expected, margins begin to shrink, debt service costs that have been manageable for businesses operating at peak profitability may suddenly become onerous. The effect could be further amplified by higher borrowing costs in a rising rate environment. 
 
We have long sought to avoid that scenario by seeking companies with strong balance sheets that are poised to see their margins grow due to internally generated improvements. These low-leverage companies, we believe, are also well positioned to reinvest in their businesses and will not have to devote precious financial resources to servicing debt in a rising rate environment.
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Author

Heartland Advisors Value Investing Portfolio Manager Bradford A. Evans

Bradford A. Evans

Evans, CFA, is Senior Vice President and Portfolio Manager of the Value Plus Fund and its corresponding separately managed account strategy. He has 22 years of industry experience, 19 at Heartland.

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