Ian Lance

Ian Lance

Portfolio manager

Have the central banks destroyed capitalism?

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‘The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in’.[1]

Last week, the triple-C-rated French telecoms company Altice Europe N.V. sold €500 million ($550 million) in eight-year senior notes at a 4 percent coupon. Altice, which has €37.4bn in net debt supported by only €5.8 billion in adjusted EBITDA and €900 million free cash flow for full-year 2020, has lost money on a net income basis in each year going back to at least 2012.

As value investors we have always believed in the existence of a capital cycle and what Joseph Schumpeter called ‘creative destruction’. This is the idea that ultimately capital will exit industries which are making sub-economic returns and that profitability will improve for the remaining participants. The intervention of central banks in recent years has, however, elongated this process. By pinning interest rates to the floor and forcing yield hungry investors to accept higher and higher risks for lower and lower returns, the central banks have interfered with the capital cycle process and hence a company like Altice is always able to obtain new funding no matter how dire their financial performance is. For the existing players, these zombie companies never exit and hence returns never improve.

In a world in which it was possible to make a low risk  5 percent in a US government bond, investors were less willing to fund loss making companies to perpetuity and would eventually demand a roadmap towards profitability. With zero percent interest rates that is no longer the case and hence companies such as Netflix can burn ever greater quantities of cash and yet watch their share price continue to rise thus creating a win-win for shareholders and viewers alike. According to a recent report from the Wall Street Journal, the share of listed companies in the US that are losing money is nearing 40 percent, which is the highest level since the 1990s outside of a recession.[2]

Source: Bloomberg, 31 December 2020

Figure 1: NFLX non-GAAP free cash flow ($MM)

Central banks do not yet appear to have made the connection between their interference in the workings of the free market and the very low rates of economic growth during the last decade. Whilst they may pat themselves on the back as the S&P500 continues to go up nearly every day, they might not feel so smug if they looked at fundamentals rather than just share prices. S&P500 earnings have flatlined for the last five quarters whilst companies have continued to take on additional debt and are at peak indebtedness as a percentage of GDP (below). This does not, to me at least, feel like a sustainable situation.

Source: HSBC, BIS total credit statistics, 31 December 2018

The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of RWC Partners Limited. This article does not constitute investment advice and the information shown above is for illustrative purposes only and should not be construed as a recommendation or advice to buy or sell any security. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment.

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