18.01.19

Snapshots has been following the story of Carlos Ghosn and Nissan and what is essentially an allegation of misconduct and the concentration of executive power. While we have no view on Ghosn’s alleged guilt, this type of corporate scandal reminds us of Dennis Kozlowski and Tyco in 2002. Both of these individuals built successful businesses and created shareholder value but got unstuck late into a corporate expansion when corporate profits were booming (as defined by percentage of GDP).

Cycles

As we said in Snapshots in July last year, we think about cycles of macroeconomic activity, corporate earnings and default rates. At the time, we said, “it is striking how the corporate default experience during the recession of 2008 was smaller than the corporate default experience during the recession of 2001.

The 2008 recession was caused by a collapse in house prices. This rippled into sub-prime mortgage defaults that led to the collapse of Lehman Brothers, which was the biggest bankruptcy filing in history. The financial sector was at the centre of the recession and the decline in GDP and rise in unemployment was the largest since the great depression.

The 2001 recession was caused (in part) by the collapse of the dotcom bubble and a series of corporate accounting scandals (Worldcom, Enron, Parmalat) that shook confidence in the corporate sector. The corporate sector was at the centre of the recession but the decline in the real economy was actually quite shallow (again as measured by GDP decline and unemployment rise).”

As we head into 2019, we think these are useful observations to think about.

Corporate Profits and Corporate Leverage

With respect to corporate earnings, there are essentially two variables to think about. Corporate profits (as a percentage of GDP) and corporate leverage. Both are at cyclical highs. This means that a small drop in sales (which correlates somewhat to GDP) is amplified on profits because of a company’s operating and financial leverage. For a beautifully elegant explanation of this, please read Howard Marks’s latest book, Mastering the Market Cycle, which dedicates a whole chapter to the cyclicality of corporate profits.

So while we welcome the very strong start to 2019, we think a cautious and selective approach to the corporate sector is still warranted.

Good luck in 2019.

Asif Godall
Co-Chief Investment Officer