A Rising Interest Rate Environment

If this is the actual long anticipated reversal in interest rates, what does that mean for you and me and what is a  good capital structure for future enterprises? (I believe that even personal finances should be thought out and well-structured. While individuals don’t have the tax situations that company’s have, they have plenty of capital allocation choices that are very similar to what a public enterprise would engage in.) The best place to start that thought is to explore what worked really well in the past. Let’s assume a hypothetical simplified business that makes widgets- Widgets R Us Inc. They require a small amount of cash on hand for day-to-day activities, maintain an accounts receivable and payable and take inventories of widget parts and turn them into full widgets which are then sold on the open market for a profit. We’ll assume some generic facts about the business and show two hypothetical simplified capital structures to illustrate the value of leverage in an inflationary environment and falling interest rates. Take a look at the simplified balance sheet and income statements below:

Widgets R Us Base Case
Widgets R Us Base Case Capital Structure

The terms at the top just govern the basic business structure and environment for Widgets R Us. The Revenue/Assets % is the annual revenue yield expected from total assets in this business and employing a standard distribution of assets for this business (i.e. the right amount of cash, A/R, PP&E, etc. to efficiently turn raw goods into a finished product). The COGS/Revenue is the total expense needed for the operation with the Gross margin simply being 1 – COGS/Revenue. The starting interest expense is the average interest ratio on all of the debt (i.e. Notes Payable and Long Term Debt) the company currently has on the balance sheet. The tax rate is the standard unmodified corporate income rate. We’ve assumed a five year compound inflation rate of 25% which breaks down to an annual inflation rate of 4.564%. Lastly, we assume since interest rates have been falling the company has the chance reissue its debt at a new and lower rate. For our example the 5 year expected interest rate is 8%, while the current one is 10%.

Next follows a very simple balance sheet and income statement. We start with both short term assets (cash, accounts receivable, and inventories) and long term assets (PP&E and Goodwill). Next is the short term liabilities (Notes Payable and Accounts Payable) and Long Term Debt. Finally, assets-liabilities=shareholder’s equity. Notes: Accounts Receivable is money owed to the company from outside sources, Accounts Payable is money the company owes to outside sources, and Goodwill is the excess fair market value over existing asset value).

After that comes a simplified income statement. We earn 40% of the total assets as an annual revenue (i.e. $6,100 is 40% of $15,250). We pay 75% of that as COGS and then pay interest expense leaving us with income before taxes. We then have to pay income taxes leaving us with net income.

The example breaks down the business into two hypothetical capital structures. The first example is with a low leverage ratio. Indeed the total debt $2,250.00 and the shareholders equity is $10,500 as compared to a total asset base of $15,250. The equity in this operation is nearly 2/3rds of the value in the business and very little of this operation is leveraged. In the second case the business is carrying $10,000 in long term debt and $1,000 in short term debt (and plans on maintaining this amount through the next five years). Now equity is a paltry $1,750 or a little over 1/10th of the total asset base of $15,250.

Columns three and four show the business in year five for both example 1 and example 2. IT IS IMPORTANT TO NOTE THAT THERE IS NO ASSUMED ORGANIC GROWTH FOR EITHER EXAMPLE. The businesses still need the required distribution of assets to operate and the only thing that has change is that inflation as increased both the price that goods can be sold at and the resulting price for the assets needed for this operation. We aren’t making the business bigger or changing products or anything else. We are just assuming that prices for everything went up! (The revenue earned increased by 25% from $6,100 to $7,025, the value of the assets needed to do that amount of revenue went up by 25% – Inventories went up 25% from $2,500 to $3,125, PP&E went up 25% from $5,000 to $6,250, etc.)

Once again we aren’t making the business bigger or changing products or anything else. Inflation has boosted our output prices and our required input prices. Nothing else. While most of the assets have gone up in value, some things have stayed the same. Goodwill hasn’t changed, since we really didn’t do any acquisitions, divestitures, etc. Our debt amounts haven’t changed. The low leverage business still carries a total debt burden of $2,250 and the high leverage business still carries a debt burden of $11,000 of combined notes payable and long term debt.

One other thing has changed. In five years we had the opportunity to refinance the debt at a lower rate due to falling rates. The interest we pay on the debt has gone from 10% to 8%; this affects our interest expense line item in the income statement. So what are the five year results for owners of this business solely due to disparate capital structures and an environment we’ve had for the last 30 years? Well there are two numbers that changed dramatically for the two businesses. The first is the amount of shareholders equity. The low leverage business (example 1) grew their shareholders equity from $10,500 to $12,187.52 for a 16% increase in value, but the high leverage business grew their shareholders equity from $1,750 to $3,437.52 for a 96.4% increase! Those shareholders made bank. In addition to the growth in equity, the net income changed due to inflation, but also due to the decrease in interest expense. We see the low leverage business growing their net income by only 21%, while the highly leveraged business grew their income by 106%!

That’s a pretty big difference in 5 years for earnings and equity. And all it took was a serious amount of leverage. It’s also important to note that the low leverage business didn’t keep up with the rate of inflation in either equity growth or earnings growth. If the low leverage business was actually publicly owned (and possibly even if it was privately owned),  the owners would be having a very serious talk with the management team asking them why they were getting paid for sub-par growth. In fact, there probably would have been a distinct pressure to change the situation (by leveraging the capital structure) or by replacing the management team. The second way of righting the business is exactly how Bain Capital makes it money! If you understand that example, you can be as rich as Mitt Romney!

All joking aside, it’s important to see where inflation and reductions in interest rates affect a company’s prospects. Inflation primarily affects the balance sheet. If an enterprise can count on a steady and positive rate of inflation, it can assume a higher leverage ratio and wait for inflation to help juice the shareholder’s returns by counting on the increase in nominal prices for inputs and outputs. On the opposite side, a reduction in the borrowing costs for capital primarily affect the income statement, if the firm doesn’t take advantage of the lowered rates to raise the amount of leverage. In a realistic enterprise, they would definitely increase the amount debt on the balance sheet to maintain the present value of the tax shield asset (pre-tax interest expense reduction in taxable earnings). In our example the constraint was to not allow a change in liabilities; this was done to highlight the effects that have been in place for the last 30 years.

And the last 30 years, in general, have been incredibly good for businesses. The constant reduction in interest rates and the continuous positive rates for inflation have allowed companies to assume higher rates of leverage to increase their rates of return. This is the primary tactic for private equity enterprises. Buy a company with large amounts of debt that are then added to the company’s balance sheet and wait for the operational turn-around (plus inflation and reduction in interest rates) to juice up the equity and earnings so that you can quickly sell. But if the environment changes what happens to Widgets R Us Inc? In the follow up articles we’ll see what happens to the two different businesses when interest rates rise. After that we’ll conclude with some actual advice.

Cheers,

Mario.

A State Transition in Interest Rates?

Just recently we have experienced what might possibly be the start of the reversal in a 30 year trend. For over 30 years, interest rates within the United States have been slowly but continuously dropping. From a cyclical high of a 15.8% yield on the 10 Year Treasury reached in 1981 to the incredible low yield of 1.63% reached earlier this year. While it was not a straight line and there were many counter-trends up, during the life of a 10 year bond you were guaranteed to not only earn a yield in interest, but to also earn a yield in principle. The constant and inexorable motion of the lowering of interest rates meant that it was always going to be easier in the future to pay of one’s debts- even if the only choice was to refinance the operation. Coupled with a constant and always positive rate of inflation, it made sense during the last 30 years to always try and leverage any activity as much as possible, continue operations until interest rates and inflation reduced the debt burden, and finally reap a return due to the equity growth in the balance sheet. The only issue that limited incredible rates of leverage was the ability to handle a short term reversal (remember Long Term Capital Management?).

30 yea10 Year Treasury Interest rate graph

That may have all changed earlier this year. The interest rate on the 10 year bond started rising from a low of 1.63% to just under 3%. And it seems that the positive change in interest rates, while large and quick, isn’t going to be stopping anytime soon.  In fact, this change might be the harbinger of a long 30 year counter trend where rates inexorably rise and there is a constant and continued reduction in operational viability due to ever increasing financing costs. (Note: The wording in the earlier sentences intone a strong sense of conditionality; this isn’t meant to imply that the result or effect is in question, but that right now no one knows if this is actually the start of a counter-trend or just a false uptick to lower overall interest rates. While people may say that there’s very little room left for rates to fall, a valid counter example is Japan where rates have fallen to well below 1%.)

 

Second Step to a New Backyard — Operation Blank Canvas

Before I can make my fabulous landscape plan a reality, I had to remove the “extra” elements from the existing backyard so we can start from a true blank canvas.  This turned from what I thought as a two step process to something much more complex.  In my mind, I knew I had to remove the trees and the grass, but I totally underestimated the difficulty and the length of time each step requires.

I began Operation Blank Canvas by removing the two trees that I didn’t want to keep, a 6 feet apple tree, and 15 feet cumquat tree.  Let’s be honest; one produces poor quality/quantity apples and the other extremely sour fruits that I have no use for.  I hired my parents’ gardeners for this task.  $300, 3 strong men, and 4 hours later, both trees where cut down and removed.  Unfortunately, the cumquat tree was so large that it left many smaller roots  in the ground that they couldn’t do much about.

Removing the grass turned out to be a more involved task and took many months to complete.  The first step was to kill the grass.  Sounds easy, right?  Not so much in reality.  The instruction from my landscape designer was to generously spray the entire yard with Round-Up, then thoroughly water the entire area when the grass begins to brown.  Spray Round-Up again when new shoots come out, then wait and water, then spray again and water again.  Repeat this spray and water process till there’s no more grass.  Since Round-Up is a systemic weed killer, watering after the initial application is to encourage the unaffected grass to grow, so the new leaves can deliver the next round of Round-Up spray to their roots thus killing the grass or weed.  In theory it was a good plan, but in reality it took many more cycles to kill the majority of grass.

A few weeks after the initial application of Round-Up, I was surprised to see that the grass had barely browned at all!  So I decided in the interest of time I needed to apply another application.  Two weeks later, blotches of grass began to brown but all came back in stride after thorough watering.  Then third and fourth application and watering, but the green grass kept coming back more resilient than ever.  In the end, this battle with the grass took me nearly three months and gallons of Round Up to kill about 90% of grass.

The weather was already getting hot so I gave up on killing grass and moved onto the next step of the project, grass removal.  For this I hired a gardener and rented a large tiller from Home Depot.  Tilling the 50 feet by 50 feet lot itself only took one hour.  The gardener spent the next four hours to hand filtered the grass out of soil.  At the end, he ended up with 15 large bags of dead grass.

Looking back at this part of my garden renovation process, it was certainly the most time consumption and energy draining, not to mention the most boring part of the process.  I admit that I didn’t do my best; all I wanted to do was to move onto something more fun.  Since then I have learned a little more.  The following are my lessons learned from this experience.

Complexity in composition of grass spies increases the difficulties in removing them.  Some grass like fescue develop deep and complex root systems that are hard for chemicals to reach, so it takes much longer to kill them and if you are not diligent they come back.  I find more nut grass around today than anything else and they are very difficult to remove.  Their nut-shaped nodules are buried 10-12 inches deep underground, and unless they are removed the grass just doesn’t go away.

It’s been months since I applied Round-Up to my yard and I am now thoroughly regretting it.  I was uneducated about the chemicals at the time and I should have seek out alternative earth friendly grass removal methods such as solarization.  In my hurry to get to the next phase, I underestimated potential damage chemical had to my soil and future crops.

Another issue I never considered was that grass removal is a long term project.  No matter which grass removal method is employed some will come back and poke their head out of soil.  I have stopped using chemicals now, but simply pull the rogue grass out of the ground. It does not seem to deter them.  I expect that I will be pulling grass for a long time to come.

If I was to do it all again, I would have performed some soil test and added back necessary organic components when I rented the tiller.  It is so much harder to improve soil quality with trees and plants already in the ground.

-Flo.

Paper Optimus

Ravi and Mom recently found out about paper fold-up transformers. A site named Cubee Art has a compilation of different fold-up dolls that you can print out, cut out, and fold-up into a transformer. When Mom showed Ravi, he was super excited and immediately wanted one created. Since it involved some pretty fine cutting with an x-acto knife, I took over and put together a couple for him. They have found a home on our mantlepiece ever since.

Enjoy Ravi and remember to not let your brother get a hold of them!

Love,

 

Dad

 

Ravi's 'Ninja' Paper Optimus (cuz it's black...)

Ravi’s ‘Ninja’ Paper Optimus (cuz it’s black…)

 

Bumblebee and Optimus Prime

Bumblebee and Optimus Prime

 

Housing Affordability Index

One should always look for metrics that help to quantitatively assess the value one gets for the price one pays. Intuitively we all do this when we look for the next big ‘deal’ or when we employ a coupon to save money. The problem with financial purchases, as opposed to typical consumer purchases, is the time frame involved. Most food is good for a month and clothes are good for a couple years. Since people also tend to cycle in and out and make multiple purchases annually, the deals have to be acted upon quickly and no single purchase is detrimental to the long term value of the product being purchased. This isn’t the case with stocks, bonds, or real estate. One good purchase can disproportionately pay dividends for future years for as long as the asset is held.

The hardest financial purchase to get right is also the largest a family makes; the decision to purchase their family home. Research shows that the average length of stay at any one purchased property is 7 years. This means that the cost you pay is fixed for a fairly long time. So it behooves everyone to make sure that when they make this purchase they are getting the best possible deal that they could possibly get. So we’re back to the original need for a strong metric to help make this decision easier. One of the most common aphorisms in finance is that a ‘rising tide lifts all boats.’ The point being made (and hopefully remembered) is that when the market goes through periods of over-valuation and under-valuation relative to average all of the individual securities are influenced to some degree. Even crappy stocks get bid up and they become more pricey than when the market was undervalued.

The same process applies to real estate. As everyone now knows we just had a bubble in real estate with both good AND bad properties being priced at the higher range of the valuation spectrum. But how to know when is a good time and when is a bad time to buy real estate? Well the National Association of Realtors (bless their black little hearts…) actually do put together and track a housing affordability metric. It’s called the Housing Affordability Index and it’s actually very very useful. The metric is based on the median single family home’s monthly PI (Principle and Interest) cost as a percentage of the median family income. As a metric it gives you the actual monthly cost basis of real estate from a national perspective. This is a very valuable metric and can help anyone determine a good time (from a bad time) to buy real estate.

Zerohedge had an article that illustrated the thirty year affordability graph and is reprinted below. The zerohedge article talks about how housing affordability (due to the interest move on the 10 Year Treasury note) has starting plunging rather drastically. While it doesn’t mean that you shouldn’t buy real estate (as its price is always, first and foremost, a local phenomena) based on the housing affordability index alone, it does serve to highlight the broad trend and helps simplify the initial decision tremendously. And the signal coming from the market right now is, if you’re in the market to buy a house, to buy quickly; prices are going up.

 

Mario.

Housing Affordability

30 Year Housing Affordability Trend

 

One month in Ravi’s Shoes…

Ravi is a little boy. As a little boy he has a very active life and does a lot of fun things. Recently we had to buy him a spare pair of shoes while on vacation. They were average shoes and not one of his regular Stride Rite light up shoes he was used to getting. Nevertheless, Ravi liked the shoes and wore them fairly regularly for about a month.

After that month we had to get him new shoes because they looked like this-

One month in Ravi's Shoes...

One month in Ravi’s Shoes…

…Sigh…

I don’t know what he had been doing to them, but they obviously were falling apart due to him kicking stuff. The funny thing is we never really saw him excessively kicking walls or fences or anything. I even asked his teachers and they didn’t see him continuously  or repeatedly kicking things. My other kid has a habit of repeatably kicking the garage door in the morning when we’re getting ready to go, but not Ravi.

Oh well, it probably doesn’t matter much as we have to replace his shoes every three to four months at this age, but it was annoying. I’m sure I’ll get over it. Especially when Ravi gets older and I make him have to buy his shoes with his own allowance money!

Hehehe!

(Though I think he’ll get around this the same way one of my high school friends did; they duct-taped the front of the shoe to  avoid having to buy a new one until their parents relented. Parents are always so much more uptight about things like that than kids ever are.)

 

Love,

Dad.