Along those lines, I was going through my "clippings file" and came across this piece in the Economist. It discusses some of the costs of excess debt during recessions. Of course, it's always easy to look back after the fact and say that firms shouldn't have levered up so much, since it means they'll face distress costs during a recession (hindsight's always 20/20, after all).
In a related piece David Merkel id a piece a while back on financial slack and how he uses it in evaluating cyclical companies in Real Money. He illustrates his approach using the steel industry. When identifying good companies in the steel industries he looks for several things:
...With a cyclical company, watching the pricing trends of the commodity produced is the most critical factor in short-run stock performance. Longer term, it comes down to finding companies that have these four characteristics:Point 4 is the most relevant to the whole leverage/payout discussion: what's the best use of free cash flow? Should it be invested, used to pay down debt, or be distributed to shareholders? If good time are expected to continue, the company is best off investing the excess in positive NPV projects and then paying out excess free cash in the form of dividends and buybacks (and buybacks result in increased leverage). However, if troble is expected ahead, they're better off paying down debt or holding more cash in reserve.
1. They're industry leaders with impeccable balance sheets.
2. They have reasonable operating leverage; they should be profitable at the cycle trough.
3. Their industry is hated, so their stocks can be bought at a cheap price.4. They use free cash flow at a cycle peak in a way that prepares for the trough.
...Points 2 and 4 suggest a corporate humility that arises from restraining the increase of productive capacity when times are good, and a willingness to invest when times are bad.
I think it'll make for a good discussion in class.
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