What is the Credit Story?

A company does not function in isolation, churning out the returns in its income statement by using the assets on its balance sheet independent of happenings in the world around it. The value of the assets on its balance sheet, linked to the income they can produce, depends on the changing dynamics of global business. Companies which operate in countries which facilitate business always start at the starting point with an advantage. Also, companies can flourish in an atmosphere where ecosystems of research and development and government facilitation through creation of an appropriately trained workforce and a world class physical infrastructure exist. Because of various inter linkages, one can’t pretend to have understood a company unless one has understood the company’s credit story (or more generally the company’s investment story of which the credit story is a subset). Merely looking at the company’s current financials informs you only how the investment story evolved in the past, not how it is likely to play out in the future.

At the heart of understanding the credit story of a company is getting a full grasp of how a company makes money now (after all, it is not a God given right) and evaluating why it will continue to make money in the foreseeable future. A credit story is not a static one. It a soap opera- of colourful changes, new competitors coming in, others going out, countries and principalities rising and falling and new trade regimes challenging the company’s ability to make profits. Regime changes on the currency exchange rate front, due to fall in a country’s investment story, impact companies operating in that country. Technology changes can convert a joyful credit story into one with disturbing uncertainties. And there is no point groping for a credit story in industries in which technology changes happen too rapidly. Creativity of a company’s management in developing new revenue streams through changes in its business model can alter a company’s investment story.

New regulations might come into force which might either hinder or facilitate a credit story. While developing an understanding of the credit story of an entity, the only things an analyst should not do are betting against human ingenuity and believing in investment stories which have a “perpetual motion machine” flavour. Beneficiaries of human ingenuity will keep changing. In fact, technology changes on account of human ingenuity disrupt the credit story of the incumbents.

During the course of a company’s investment story, it might pass through the venture phase, the credit phase and finally the vulture phase (when the company’s carcass is torn apart in a bankruptcy or liquidation court). The creditor must ensure that he is involved with a company in the correct phase and not accidentally walk into the venture phase or the vulture phase on account of an improper understanding of the company’s credit story. Unlike the fabled Schrödinger’s cat which could be dead and alive at the same time, a company operates clearly in one of the three phases at any point in time. The credit analyst’s role is to get the call right on which phase the company is in and to estimate for how long the company would continue to be in that phase. There is no inevitability to the company moving from the first phase to the second, nor from moving from the credit phase to the vulture phase. And companies can also move back from the credit phase to the venture phase. Silicon Valley is there to testify to the fact that companies can go straight from the venture phase to the vulture phase. But calling the end of the credit phase of a company is crucial else, when the clock strikes twelve, the creditor could be left holding a non performing loan when the credit story has turned into pumpkin.

The credit story is based on hard facts. It must rest on solid ground and not based on the assumption that the company’s competitors will forever be incompetent or flat footed. In fact, it is everything that a typical equity research report of an investment bank is not. With due apologies to Shakespeare, an investment bank’s equity research story is usually a tale told by an idiot, full of sound and fury, signifying nothing. There is a lot of hope and hype built in. The story is usually built around aspirations and assumptions that contort common sense. It has everything to do with pumping up a company’s stock price and very little to do with prosaic reality. Since the creditor does not get a share of the upside if any of the hopes of a venture investor turn true, there is absolutely no incentive to chisel the credit story around anything but hard facts and a conservative estimate of likely future earnings. This is based on identifying the drivers of the company’s earnings and how those drivers could change over time.

In the past, creditors could rely on the pace of change of a company’s credit story to be slow. Technological changes were slow. So, a creditor who was slightly slow in picking up the signals of imminent change always had the time to recover. That will not be the case in future. Changes to the credit story can happen really fast. In 2001 American futurist Ray Kurzweil propounded the law of accelerating returns. The law implies that returns (such as increase in speed of a micro-chip or decrease in its price) would not increase at a linear pace but at an accelerating pace. According to him the progress in the hundred years of the twenty first century would be like 20,000 years of progress at today’s pace. As an extension, one can argue that the moment a particular level of momentum builds for adoption of a particular way of doing things or acceptance of a particular technology (say battery operated cars), the pace of change accelerates at an accelerating pace. This accelerating pace can change credit stories so fast that a non-alert investment analyst would risk missing the whole plot.

     An Excerpt from the book - Stories in Credit Analysis

How to protect your investment portfolio from credit rating agencies, quants and other quacks

Author – Conrad C Vincent