MEDIA RELEASE: Investors should be scrutinising the financial leverage of any potential investment, especially in the current economic cycle when rates are still rising and the pace of growth is slowing, says Talaria Asset Management co-chief investment officer Hugh Selby-Smith.

Selby-Smith says companies that have a higher level of total debt – excluding cash - face risks around the repricing of that debt and the widening credit spreads associated with that debt.

“Companies who will soon need to refinance in the debt market are particularly at risk in this environment - so the structure of a company’s balance sheet is a potential red flag for investors,” he says.

“In addition, businesses that provide a degree of financing to their customers - whether by carrying large amounts of inventory or lending on generous payment terms - are also at risk of having a liquidity issue.”

At the company level, Selby-Smith says it is an environment where a strong balance sheet, high returns on equity and assets and relatively dependable revenues streams that are priced sensibly are a good place to be invested.

He cites pharmaceutical companies such as Swiss giant Roche as a good example, as well as relatively low capital intensity businesses with stable margins such as distributors of products and services Mckesson in the US and Bunzl in the UK.

On the macroeconomic front, Selby-Smith says the already slowing global economy is set to decelerate further as access to credit for business and individuals is likely to become more difficult.

“The most recent survey of senior loan officers by the Federal Reserve in Q4 2022 - which addressed changes in the standards and terms on, and demand for, bank loans to businesses and households - showed a net 40 per cent of respondents were tightening standards for commercial and industrial loans and increasing the rate charged on those loans.

“Demand for credit slowed as a result. The woes seen in the US and European banking sector over the last weeks will only make these standards tighten further and therefore costs move higher for borrowers, adding to the already considerable economic headwinds,” he says.

Aside from lending standards, Selby-Smith says the most important leading economic indicator is the US Institute of Supply Chain Management’s (ISM) manufacturing survey which leads the outlook for corporate profitability both in terms of level and direction.

“A manufacturing ISM above 50 signals the economy is expanding, suggesting an increasing level of future corporate profitability. Below 50 suggests a decreasing level.

“The ISM is currently below 50 and has been trending downward since June 2022. With interest rate increases yet to work their way through the broader system, the balance of probabilities therefore is heavily weighted towards falling indices and negative returns.

“As we have said before, in this environment equity investors should prize income, good value, short duration and rapid payback periods. They should avoid high beta shares, those with prices that can be largely or more than fully explained by overall market moves, and they should avoid financial leverage,” Selby-Smith says.