There has been a decent number of going concern recently from fellow bloggers that taking on debt is seen as a no go and some even try to completely avoid them as they are seen as a bad apple. Similarly, the approach these very same people take when it comes to investing is to filter off companies whose debt or gearing ratio reaches a certain threshold, say above 50% or 70%, depending on one threshold.
While the above imposes certain sense of prudent investing, my purpose of writing today is to open up an explorable idea that undertaking certain kind of debts need not inherently be a bad idea and if you are one of those who filter off these companies completely just because they are laden with debt, you may be missing out on some good companies out there.
Just like how using credit card prudently can be beneficial to most of us, a company that uses debt need not be inherently bad. As a matter of fact, debt is almost always a much cheaper form of financing than equity. Take MGCCT for instance, their current gearing stands at 38.6% and costs of debt is at 2% due to their ability to obtain financing during the period of low interest rate environment for their strong sponsor. If you are one of those investors who have strict criteria in your investment to filter off companies with gearing more than 35%, then you would inherently miss out on this counter. In fact, MGCCT is one of the few reits with the one of the lowest costs of debt out there and yielding pretty decent returns for the shareholders. Their ability to cover these interest costs are also pretty decent with coverage ratio at 4.8x.
Secondly, debt can also be a form of tool to boost the company’s Return on Equity (RoE), especially when their other levers such as operating and asset efficiency are not performing well. Ironically, I have encountered a blogger who avoided investing in Reits because of the high leverage but choose to invest in Starhub instead. I’m unsure if he realises that Starhub has a pretty high debt/equity ratio, coming down from as high as 16x to the current of 8x.
Third, gearing of a company is often a function of both the numerator and denominator – liabilities over equities or assets. But many investors look at gearing as a form of control only on the liabilities side and often the other part was neglected. Take SPH for instance, when they spin off their Paragon and Clementi mall into the SPH Reit, their gearing falls from 40.6% to somewhere around 8%. The immediate reaction from the crowd was the amount of debt goes down but that is not the case. Apparently, gearing goes down because equities have now risen resulting from the sale of those assets. Similarly, most assets are revalued at least once a year so this will also affect the nature of the gearing.
Finally, I am writing this post not to debate whether taking on debt is a good or bad thing but rather hoping to open up how people can view debt in a different light. Just as Howard Marks view risk differently than the traditional with higher risks not necessarily equal to higher returns, the same view can be said with taking debt and they are often not necessarily a bad thing to have in your balance sheet.