We see a million articles about the “fiscal disaster” of the U.S. government, the one entity that literally cannot default in the traditional sense of failing to repay as promised, but let’s be honest, do most investors have any idea how much debt is lurking in their portfolios?
Corporate debt and the amount of leverage in the corporate sector has taken a backseat to discussions around fiscal responsibility at the federal level. The most recent Federal Reserve Financial Stability report noted, “gross leverage of publicly traded corporations edged down but remained near the upper part of their respective historical ranges.” And let’s face it that assumes the Fed can even measure all of the debt in the system appropriately.
You just don’t see a ton of articles talking about corporate debt and leverage, until you do (does anyone remember concerns over leveraged loans in 2019?), and that’s usually not until something is broken. In the meantime corporate reports give you the data you need to help better understand how much leverage companies might be running.
We talked about leverage here. And if you want a deeper read, this Howard Marks memo is one of my favorites, summarizing leverage as:
“Leverage is neither good nor bad in and of itself. In the right amount, applied to the right assets, it’s good. When used to excess given the underlying assets, it’s bad. It doesn’t add value; it merely magnifies both good and bad outcomes. So leverage shouldn’t be treated as a silver bullet or magic solution. It’s a tool that can be used wisely or unwisely.”
If you’ve ever nodded along while someone said “ROE looks strong,” but didn’t ask, “Yeah, but why?”, then allow me to reintroduce you to your friend DuPont.
DuPont, Not Just For Chemicals, But Decoding Returns
The starting point of DuPont analysis, or the decomposition of ROE, is that ROE is a function of how much a company earns from its assets and its use of financial leverage. Companies can juice their ROE by earning more from their assets or taking on more debt.
ROE = Net Profit Margin × Asset Turnover × Financial Leverage
Translation: how much you earn on each sale (margin), how many sales you wring from your assets (efficiency), and how much of it you turbocharge with debt (leverage).
But the key here is this: leverage is a multiplier. A beautiful one when things go up. A wrecking ball when they don’t.
While companies seem to be covering that interest cost currently, the potential refinancing of longer term debt can still be a source of risks to companies earnings and investors returns. And if you listened to Jamie Dimon yesterday, he sees risks to corporate earnings.
A company with 15% ROE might look like a gem until you realize it’s built on 7x leverage and burning through cash to keep the dividend alive.
Is Leverage A Risk You Don’t See?
Morgan Housel once said, “Risk is what you don’t see.” Leverage is often exactly that—hidden in leases, obscured in footnotes (remember “Repo 105” and Lehman), normalized through buybacks. Generally unseen until it’s not.
This isn’t just a stock-picking problem. If index returns are juiced by levered ROE across sectors, what happens when that leverage turns from friend to foe? Valuations start to compress—not just because growth expectations fall, but because debt starts to demand its due.
So yes, DuPont is dusty. But in a world where debt isn’t cheap anymore and ROE math isn’t magic, maybe it’s time to revisit the fundamentals.
Because if you’re holding companies whose returns are just borrowed performance, you might want to check what’s backing them.
And A Day After Moody’s Downgrade…
Corporate credit spreads were little changed in the face of the Moody’s downgrade as investors don’t believe country risk extends to corporate risk. Yields on U.S. treasuries rose some only to retreat and ended the day little changed. The S&P was able to extend its winning streak to 6 days.
Fed officials continued to stress “wait and see” and you’re likely to hear the same message today.
In the meantime, ponder how much financial leverage you own via the S&P 500…and that’s before we even get around to talking about operating leverage.
XTOD’s:
XTOD: CEO Jamie Dimon: "Forward P/E ratios are around 20 or 21 today. And you know, tariffs do affect the E...Earnings forecasts will come down. We started the year expecting earnings to be up 12%. Now it’s more like 6–7%. My guess? In six months, that could be zero. So earnings estimates have dropped—and that probably means P/E ratios will drop too. If P/E multiples fall by just one turn, that’s another 5% down. So between earnings and valuation compression, you could be looking at a 10% market impact. I think that’s a likely outcome, in my personal opinion",
XTOD: Wild. "PE distributions have fallen from 29% of NAV from 2014 to 2017 to only 11% last year. Endowments are rushing to complete sales ahead of potential changes to taxes, which could rise from 1.4% to 21%... 'We recently looked at a portfolio at 80-85 cents on the dollar'."
XTOD: Shocking to literally no one, Buy Now Pay Later loans are a ticking time bomb
XTOD: Jeff Bezos on creating a culture for missionaries: https://pbs.twimg.com/media/GrVrWhnXEAETEg-?format=jpg&name=900x900
https://x.com/TheTranscript_/status/1924496760786874800
https://x.com/TidefallCapital/status/1924497898412118404
https://x.com/VladTheInflator/status/1924526771934032363
https://x.com/FoundersPodcast/status/1924562453624479921
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