The Reserve Bank of Australia (RBA) announced this month that it would keep the official cash rate at 1.5 per cent for the twenty-first consecutive month. This extended period of low interest rates has benefitted companies in several ways and been a key driver in company decision making around capital allocation. Put simply, we feel the extended period of low and falling rates has resulted in boards and management taking on more financial risk.
Perpetual has observed over this time:
Lower interest costs driving improved company profits;
Funding acquisitions through debt. The cheaper cost of debt has been a key driver in acquisitions being earnings per share accretive;
The use of free cash flow to return capital to shareholders through on-market share buy-backs or increased dividend payout ratios, rather than paying down debt; and
In some cases, borrowing to fund dividends.
At the same time, companies that have maintained a conservative balance sheet and used the falling cost of debt to reduce leverage in their business have not, in some cases, been rewarded by the market with a higher stock price, or higher P/E ratio, to reflect the strength of their balance sheet.
This low interest rate environment is due to change and when it does, the tailwind bolstering companies will become a headwind. It will be those companies with conservative balance sheets that will end up the biggest winners.