When You Are Wrong—Really, Really, Really Wrong

Chapter 5 expanded on how Question One helps uncover false myths “everyone” knows, even though no one bothered to fact-check. More exciting, you can find myths so broadly, irreversibly and passionately held, the exact reverse ends up being true. Where mythology is so really, really, really, really wrong, it’s actually backward—like our example of federal budget deficits leading to great stock market returns instead of disaster. You link a Question One to a Question Two and learn the exact reverse of common mythology is a bet-able truth. We’ll demonstrate a few of those in this chapter to show you how you can do it on your own. Just start with anything people are intensely righteous about. You may be labeled a heretic by acquaintances, but so what? (It’s not your business what people think about you, remember?) One reason so many investors fail is they fear asking questions that make them seem like crackpots. Don’t fear being seen as a crackpot—fear making bets based on possible fabrications.

When Debt Is Good!

Let’s begin by exploring a topic sure to unite just about everyone, regardless of creed, in an appalled uproar.

Debt.

In Chapter 1, I showed how the universally deplored federal budget deficit historically hasn’t led to poor stock returns—rather to good ones. I showed you the data—the what—but not the how and why. For that, you must understand debt and deficits better—know something others don’t and see how they’re used, abused and misconstrued. (As I update this in 2011, many will be particularly sensitive about debt because of the 2008 credit crisis and the eurozone debt woes that came to light starting in 2010. But nothing fundamentally has changed about the economics of leverage—though the fear of debt may be greater or smaller from time to time.)

From infancy, we’re taught debt is bad, more debt is worse and loads of debt is downright immoral. In fact, for many centuries, collecting interest on a loan was considered a sin throughout Christianity—leaving money lending to seemingly shadowy social fringes. Never accused of being the life of the party, Cato the Elder equated usury with murder. Early Christianity, Judaism and Islam all prohibited lending with interest. (Jews weren’t permitted to charge interest to other Jews, while Shariah law prohibits charging interest to this day.)

Investors perceive our debt and budget deficit to be a massive economic drain because eventually someone will pay it back—creating a presumed stranglehold on our children, our children’s children, their children, their pets, the future aliens who colonize those great-great-great-grandchildren and the cockroaches that overthrow them all—living, debt-laden, in a Mad Max post-World-War-III-style world where there’s no Mel Gibson to save us. All because of debt!

Everyone knows we’re over-indebted. You read it everywhere—and it’s rarely (if ever) challenged. And everyone agrees someone must pay it back. And when that happens, it will be heinous. Stocks can’t rise into that, right? Let’s ask Question One and see. Is it true debt is bad for the economy and stock market? Are we really over-indebted to the point of difficulty?

For this question, you must know how much debt we really have, properly, in scale. Then you must ask a question so basic no one ever asks it (but you will, very soon).

But first, some scaling. As I update this in 2011, the US has about $9 trillion in federal debt held by the public.1 (I don’t count intra-agency debt because that’s money the government effectively owes back to itself. What matters is what the government owes other people.)

Nine trillion is a lot of anything in absolute terms. For perspective, just one trillion is 1,000 billions. And just 1 billion is hard for our Stone Age information processors to conceive. For example, a billion hours ago, our ancestors were in the literal Stone Age. A billion minutes ago, Jesus lived. So $9 trillion seems overwhelming.

But is it bad? Most people think so. But remember Chapter 3’s bunnies and Hummers? You must think relatively and consider scale whenever you see big numbers. For that, you need an accurate picture of the US hard asset balance sheet (see Table 6.1).

Table 6.1 Aggregate Hard Asset Balance Sheet of the United States

Sources: Standard & Poor’s, Federal Reserve Flow of Funds Accounts (3Q 2010).

Note: Other assets and liabilities considered one-for-one offsets excluded. Examples of such items are life insurance policies and reserves, consumer durables like a sofa or dishwasher and pension obligations and benefits.

Unless you’re a client of my firm, you’ve probably never seen a balance sheet for America presented this way. (Though all these data are publicly available, my guess is people just don’t think to do this.) It’s built just like a business balance sheet totaling all US assets and liabilities—including public and private debts. Adding up the left side, the asset line items give the United States approximately $129 trillion in total assets. (Nine trillion immediately feels smaller, doesn’t it? Scaling!) Moving to the right side (the liabilities side), we have $64 trillion in total debt outstanding. As with any balance sheet, subtract the liabilities from the assets and you get America’s net worth of about $65 trillion. (Note: Our balance sheet doesn’t address assets and liabilities that are contractual one-for-one offsets, like life insurance policies and reserves and pension obligations and benefits. Since they perfectly offset each other, they don’t impact our analysis, nor do off-balance sheet obligations like Medicare and Social Security—ones easily later politically eliminated by a vote of poli-tics.)

What Is the Right Amount of Debt for a Society to Have?

But a better question—the real killer question, a Question Two—is: What is the right amount of debt for society to have? And how would you know it was the right amount? This is a question I’ve never heard asked in public or commented on—ever. It’s a Newtonian-like question because at its roots are heretofore unthinkable fundamentals. What is the right amount of debt of all types for a society to have? Most folks presume less debt is better and the best amount is none.

But we know that must be silly. Look at corporations. They generally use debt to finance their activities prudently—do it all the time. They do it to maximize their net worth over time by achieving a higher return on assets than their borrowing costs. Having no debt isn’t optimal, so what is optimal? How would you figure it out? It would be an amount where having more debt would be bad but having less debt would also be bad—that is, just the right amount. No one ever thinks to ask what that level is because their confirmation bias leads them to presume less debt is always better. Maybe you do, too, but you can benefit by asking Question One to see if you could be wrong. Because if you’ve been wrong about this, you’re in vast company.

To find a “correct” level of debt (and what the “incorrect” level is), we must revisit basic economics and finance theory where we learned debt by itself isn’t bad, immoral or a sign of character weakness. Debt is obviously a right and necessary tool of capitalism. And we’ve already defined capitalism as inherently good. An early lesson of corporate finance is how to calculate an optimal capital structure for a firm or the right mix of debt and equity to maintain on a corporate balance sheet. If you’re a CFO, you calculate the optimal capital structure for your company to capture maximum return on investment. Though this is different for different firms, and even varies sector to sector, the right debt level is almost never zero. Most firms can’t maximize profit without leverage. Therefore, having no debt isn’t optimal for a society. So, again, how much?

Borrowing—whether you’re a CEO running a $100 billion behemoth or a mom running a five-person household—is good if the after-tax cost of borrowing (the interest rate) is sufficiently lower than the conservatively estimated expected rate of return on a contemplated investment. Most easily agree with that. The spread between the two, quite simply, is profit. An optimal debt-to-equity ratio is achieved when the incremental borrowing cost just equals the incremental return on investment from those funds.

The “just equals” part makes some nervous. But if I told you our widget firm had a 15% return on investment from widgetry and a borrowing cost of 6% pretax (say, 4% after tax), you wouldn’t be upset if we borrowed money and added on to our widget plant. You know we would make money on the spread, and you’d like that. But still—“just equals” is scary.

Did you take microeconomics in school? If not, bear with me for a few sentences because the next few lines are for those who did. If you did, you recall in economic theory, profit maximization occurs when marginal costs equal marginal revenue (sales). (You can get that from any introductory microeconomics text. I’m not saying anything racy here.) One marginal cost may be interest costs from borrowing. Via what they taught you in school, when the marginal cost of borrowing just barely exceeded the marginal return generated from the activity in which the borrowed funds were used, optimization did occur. Because we would have borrowed all we could use to profit by—being maximally efficient—and no more!

The “Right” Amount of Debt

The right amount of debt for society to have is that amount where marginal borrowing costs of all kinds equal marginal return on assets of all kinds. This is very simple, purely rational and straight from economic theory. So extend that. If a society’s return on assets is very high compared to its borrowing costs, it could borrow more money, invest it and get the return on assets to make its citizenry richer. For those still hung up on morality and debt, a richer citizenry is moral. A poorer citizenry is immoral. Got that?

When it comes right down to it—whether more debt is good or bad or less debt is better or worse—it’s all about the return on assets. If return is high relative to borrowing costs, more debt is good, less debt is bad. If the reverse is true—if return on assets is lower than marginal borrowing costs—less debt is in order. So how do we know if the United States has the right level of debt? Simple—by looking at our return on assets relative to borrowing costs. How do you do that?

To figure our borrowing costs, look at the liabilities side of our balance sheet again. You know approximately what the interest rates are on the various types of debt. (As I update in 2011, interest rates are even lower than they were when I originally wrote this!) The interest on home mortgages for the most part is tax deductible, so that cost is lower than you think, but it hovers around 4% right now for 30-year money2; after tax is maybe half that. Credit cards have higher interest rates, but credit card debt as a percent of overall debt is much lower than many think. When you average in auto loans (which are still basically interest-free), the rate on aggregate consumer debt isn’t so high. We’ve discussed corporate borrowing rates in this book as well as federal debt. And intuitively, you know state and municipal debt, being tax-free, are lower rates still. Looking at all of the debt together, it’s safe to assume our average interest rate for all our debts is about 3% to 4%. Give or take. And after tax it is lower, maybe 2%. Something like that.

Surprise!

What is really important is the US return on assets, but how do we figure that? Just like a corporation does! Take our total income (GDP) and divide by our total assets. Based on the data in Table 6.1, GDP is about $15 trillion. GDP is the right number to use because it’s our national income, and someone receives and benefits from every bit of it. Our income is our “return”—in many ways no different than the income a family or corporation gets, which is how they calculate their return. When we have more income, people are overall better off (which is the goal). More income for more people—that’s more moral. And while you don’t think about it this way, GDP is an after-tax number, too—taxes wash out because your income tax is still included in GDP. It’s just the part our government gets. So dividing our GDP by our total assets gives us a return on assets of 12%. (That’s as of 2011. Interestingly, it was also 12% when I first wrote this in 2006—Americans are good at producing a decent return on assets.)

Quite obviously, our return on assets is much higher than our after-tax borrowing cost of about 2% to 3%. So the way a good CFO would consider it, we’re not over-indebted, we’re under-indebted. And if our guess as to the average borrowing rate is off a bit or GDP or total assets is a little off because government accounting is inherently sketchy—it doesn’t really matter much because however wrong we are, our borrowing rate is still tiny compared to our return on assets.

First, a 12% return on assets is impressive—very! Second, though this will be harder for readers in 2012 to believe than it was for 2006 readers, we’re nowhere near over-indebted.

To get to that point where our return on assets about equals our borrowing cost, we’d need to borrow and invest a lot more—maybe two or three times more. If we borrowed a lot more, eventually that would put pressure on interest rates, driving them up. And if we buy enough more assets, we would eventually engage in ever more marginal activities and our return on assets must eventually fall. But before we get to that point, overall societally, we must acquire much more in assets producing a higher level of absolute income. And borrowing more to invest and produce more income is exactly how you move to optimization in economic theory.

We maximize profit and wealth for our citizenry when we do, and until we do, we’re under-indebted. My guess is this goes against everything most readers have ever been taught. My point isn’t to advocate for more debt. Rather, I want you to see that nearly everyone fears we are over-indebted when, applying basic economics and finance theory, it’s easy to see we are very, very far from that point.

Is More Debt Bad . . . or Good?

This is the ultimate Question One. No one has bothered to ask if we have too little debt. And they don’t because consensus mythology is so overwhelmingly pro-debt reduction. It’s like some kind of sociological religion where questioning the mythology makes you a heretic. But flipping Question One on its head is about the most fun you can have in finance. Let’s get really perverse: Is more federal debt actually good for our economy and stock market? How about this question: If we’re under-indebted, how much more debt should we have, and what could we do with it? That is the Question Two kicker part that, when answered, lets you fathom something others can’t fathom. To see this, we start thinking from a corporate view and then move through individuals to government debt.

One consideration firms look at is their debt-to-equity level. Optimal debt-to-equity levels will differ from industry to industry and even firm to firm. Going back to Table 6.1, the US has a debt-to-equity ratio of about 99% (debt divided by net worth). But is that high or low? Problematic or not?

Look at it this way. Time Warner, a perfectly fine, well-run firm, has a debt-to-equity ratio of 350%. Deere & Co, one of America’s oldest firms, has debt to equity of 348%. Marriott’s debt to equity is 722%! Sunoco’s is 270%, Kellogg’s is 264%, Lockheed Martin’s is 269%, Boeing’s is 207%.3 I could rattle off many, many more.

You know all these firms. They aren’t fly-by-night. They are long-standing firms and some of America’s largest. They have much huger debt-to-equity ratios than our nation as a whole and aren’t in some way doomed. These firms may not be at their optimal debt-to-equity levels, but near as I can tell, they aren’t approaching disaster and manage to have decent earnings over time—even with their relatively big debt loads. That’s not to say the US should have a debt-to-equity ratio so high. Rather, that you shouldn’t automatically assume 99% is bad or wrong.

You may say, “I’m ok with corporate debt in theory. And I have no problem if Boeing borrows to build a plant to make money or if corporations in general do—they’re rational about their usage of it—but not for idiotic consumers or, worse by far, the idiotic government.”

What you aren’t ok with is a heroin addict ringing up credit card debt to finance more heroin and buying Pink Floyd songs on iTunes—squandering meager borrowed funds on drugs and foolery. What an idiot! Still, many of you are more ok with the heroin addict’s iPod debt than our federal government’s debt—because you feel the heroin addict is basically smarter, more disciplined and a better spender than the federal government. As far as total governmental debt goes, you hate your local municipality’s debt but see it as less stupid than your state and your state as less stupid than the federal government. (Unless you live in California—then you see the state as more stupid.)

To see the government’s and heroin addict’s debt better, let’s start with corporate debt again. Suppose you’re CEO of an average-quality corporation with a medium-grade Standard & Poor’s credit rating of BBB. In mid-2011, your company could borrow 10-year money for about 4.6%.4 To afford this debt while generating additional income, you need a return on assets better than your net after-tax borrowing cost. Suppose you have a 33% corporate tax rate. Then your 4.6% borrowing cost is 3% after tax. If you don’t believe you can beat 3% a year over the long term, you shouldn’t be CEO in the first place and your board should fire you.

So if you can build a plant or launch a product or otherwise do anything yielding maybe a 12% return—but anything markedly higher than 3%—your shareholders (and your customers and employees—in other words, everyone including the general citizenry) will like you better if you borrow more and invest to create wealth. Borrowing then is good for everyone and moral and right.

Here’s a good example of debt and corporate morality. Assume you’re CEO and your stock has a P/E of 16, which is an earnings yield (E/P, the reverse of the P/E) of 6.25%. Recall, that’s after tax because the P/E was after tax. If you can borrow at 3% after tax and buy back your own stock, reducing available supply, you boost your earnings per share, capturing the 3.25% spread as profit—getting free money for your shareholders. Done right, it’s effectively a no-lose trade as long as your earnings aren’t about to fall otherwise. And if you’re the CEO, who would know that better than you? (Again, you should be fired if you can’t do that.) It’s the moral thing to do.

But maybe not! Maybe you have higher uses for borrowed money because you can build a plant making widgets yielding 15%. More power to you. Do it—instead of buying back your stock. Or do both. You are borrowing responsibly—and possibly should keep borrowing more—as long as you have abundant opportunities to make ready profit at high returns materially exceeding your borrowing costs. That’s rational and shouldn’t have the mental sting normally associated with debt in our society.

Using debt in these ways provides capital for research, development and making acquisitions; increases shareholder value; and improves long-term prospects for the firm—we all understand that. The company in turn provides better goods and services for a more competitive price, which benefits the consumer. And let’s not forget the employees who receive better salaries, health care and other benefits because of the growth involved. It’s beautiful!