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What Would Graham Think About Debt Today?

October 30, 2008 – Comments (0) | RELATED TICKERS: TWIN , AHR , CEM

I came across an older post doing a search for Graham in google. It was made in July.

I started looking through it, and trying a screen to see if I could come up with anything.  Then I realized that when I did one of the adjustments for debt, I ran out of stocks that would show up on the screen.

Then I thought about it.  When Graham came up with this screen, we were still on the gold standard.

Lets say you can get a 6% interest rate loan, and inflation is 4%.  The equivilent intrest rate for the loan would be 2% back then.  So if the interest rates back then were 4%, you could afford to pick a company that takes twice as much debt on, to represent the same value. So if Debt/Book Value was supposed to be less than 1, you could adjust it, and make it less than 2.  If the interest rates were the same, at 6%, you could take on 3 times as much debt, if those numbers I provided were right (I didn't look it up, it's just an example).

But remember, the government numbers that you hear is CORE inflation, ignoring food and energy inflation.  And the interest rates keep dropping. As this happens, not only do loan rates go down, but inflation goes up. At some point, it's almost MORE valueable as a business to go out and get as many loans as you can to buy assets, and inflation is higher, so they have more incentive to borrow now, pay back with less valuable mony later.

Unfortunately, there is a serious problem with this.  And that's the volitility during credit crunch. In periods of deflation, the money can't flow out fast enough to make up for the lack of money in the system needed for everyone to pay their loans.

For example, If there is 1 trillion dollars in the system, lets say all the credit out their requires 1.05 trillion dollars to be paid back to the federal reserve.  Now unless you print .05 trillion dollars, and loan it out to the banks, and the banks loan it out, there's not enough money in the system to possibly pay it all back... but eventually you keep putting out money, and the interest compounds, and the amount owed is far greater than the amount of money in circulation. And so you not only need to worry about the flow of money slowing down, but also the inescapable period of time where you can't possibly print money fast enough.

So regardless of how much money you print, it's all going to have to deflate, and periods like these will be painful on those that are in debt, unless they can use fancy accounting tricks like refinancing and amortization, and taking out equity loans and things like that.

I wonder how Ben Graham's model would change.

Would he love companies that take on debt, provided inflation was high enough, knowing that as long as they have positive equity and positive cashflow that they would be able to borrow more valuable money now, to buy things that will inflate in value, and pay back the loan with less valuable money in the future?

Or would he recognize that their is greater risk in companies that have debt, as inflation may eventually turn to deflation, the nation contracts, the cashflow and earnings takes a big hit, etc, and find another way to protect himself from the major declines that he saw from 1929 to 1932. 

Perhaps he would avoid investing in companies in countries unless the countries also fit certain qualifications, such as a lower money supply, interest rates above a certain amount, and a positive GDP?

I'm pretty new as a value investor, but I know how to read a balance sheet. I've only just started reading Graham's book (the intelligent investor)...

So perhaps someone that knows more about Graham can give this one some thought and let me know what you think. Just brainstorming a little.

Anyways, as long as I'm typing, from a screen that contained SOME of the qualifications,

 div yield >=1.8

P/book < .66667

P/E (current/5 yr high)<=.6

Current Ratio > 2

5 Yr Historical EPS growth (software doesn't have 10 year as an option) >=7

(Current Assets - Current Liabilities )/ Market cap > 1.333

I came up with names: ABR, ASFI,CT, AHR, CSE, LNC, HDNG, FORTY, CEM, MOV, TWIN.

(double check these names because I guess sometimes the screening software does some weird things.)