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Corporate Deadweight Leads Race to Bottom

December 17, 2018

In his 1987 letter to shareholders, Berkshire Hathaway Chairman Warren Buffet quoted Benjamin Disraeli, who lamented, “What we learn from history is that we do not learn from history.”

 

While that will always be true to some extent, it is particularly true now with respect to our economic situation. We’ve been in boom times for a while, but even good economic cycles end.

 

And when this one does, the slump will affect people who didn’t recover from the last recession, people who did and don’t remember, and others who didn’t feel the last one at all.

 

It will happen eventually. But when?

 

The hopeful outlook is sometime in 2020 or beyond. However, current data suggest a quicker, harsher reality.

 

Right now, there are established businesses out there with bleak futures ahead. And there’s one measure that’s telling – a firm’s interest coverage ratio, which measures the firm’s ability to pay the interest on its outstanding debt.

 

In particular, if an established business has an interest coverage ratio of less than one for the last three years or more, it’s a good sign the firm is in trouble.

 

Currently, 16 percent of U.S. publicly-listed companies fall into that category. And when you’re a part of that group, it’s tough to get out.

 

Of course, these firms can stay afloat, particularly if they sell bonds on the junk bond market.

 

The problem with this “solution” is that it hurts healthy companies by prolonging the inevitable. Lenders prop up the “junk” firms, thinking it’s just a matter of time before prospects change, when the firms should probably just be left for dead.

 

We’ve seen it before, and we’ll probably see it again. This is how recessions happen, and it seems we haven’t learned from history.

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