Tripped up by a Low Hurdle

One of the unintended consequences of the Fed’s easy money policy over the past nine years has been a real-world lesson on the law of diminishing returns. As the chart shows, the drop in real rates on the three-month Treasury has coincided with a rise in the percentage of money-losing companies among small caps.

Negative Real Interest Rates Enable the Money Losers 

Heartland Advisors value investing interest rate and money flow chart

Source: ©2018 The Leuthold Group, 1/31/1994 to 6/29/2018
Real 3-Month Treasury Bill Rate: 3-month Treasury Bill minus trailing 12-month consumer price inflation. % of Small Cap Companies Losing Money on 12-Month Trailing Basis: Universe defined as bottom 2000 companies among the largest 3000 U.S. companies ranked by market capitalization in Leuthold’s Database. 
Past performance does not guarantee future results.

The relationship seems counterintuitive—lower borrowing costs should provide a break to cash-strapped businesses. Instead, many CEOs have viewed lower rates as a green light to borrow more in pursuit of speculative projects, and many have not panned out.

With the 10-year Treasury nudging back above 3% recently, and the London Interbank Offer Rate (LIBOR), which is used to set rates for many commercial loans, jumping more than 100 basis points in the past year, it appears the days of cheap money are winding down. As borrowing costs escalate, some money-losing businesses will no longer be able to subsidize their weak results and will face a day of reckoning as they are forced to pay for underperforming ventures.

We have always viewed strong balance sheets as an important factor when making investment decisions. With corporate debt near a historic peak relative to gross domestic product, we believe this emphasis will prove critical in the coming months.

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Heartland Advisors Value Investing Portfolio Manager Will Nasgovitz

Will Nasgovitz

Nasgovitz is CEO and Portfolio Manager of the Select Value, Mid Cap Value, and Value Funds and their corresponding separately managed account strategies. He also is CEO of Heartland Funds. He has 19 years of industry experience, 15 at Heartland.

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Past performance does not guarantee future results.

Investing involves risk, including the potential loss of principal.

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