Despite the mysterious disappearance of over 22% in stock valuations on Black Monday, the Dreyfus Capital Value Fund dropped less than 2% that same dark day, its equity emphasis notwithstanding. It was no surprise, then, that the portfolio turned out to be 1987's top performer among domestic nongold, nonspecialized, diversified mutual funds, gaining 34.5%. The surprise came later, when the fund's managers offered their views on 1988 and beyond.
The managers in question are Comstock Partners Inc., a seasoned trio of investment analysts. Contrary to general expectations, they see no early return to inflation and higher interest rates. Rather, they say, the major economic trends are deflationary, and interest rates will decline for some time to come. But they do not believe cheaper money will stimulate the economy this time around.
That's comeuppance for an overabundance of credit in recent years. Thanks to the ready availability of leverage, total indebtedness has grown to an estimated $11 trillion. In effect, we have had too much money (credit) chasing after too few goods (business assets), producing the predictable result: price inflation of assets. The banks, in turn, have viewed this inflation as solidly appreciating collateral. "The more inflated the price of the item," Comstock observes in a recent strategy paper, "the more likely the banks are to regard it as a sound basis for the extension of further credit," and they have acted accordingly.
But somewhere along the line, this pyramid of debt is supposed to be retired. Comstock sees the recent collapse of corporate valuations as a sure sign that time is running out. Companies no longer have the asset base, or the earnings power, to support all that debt, and so a critical mass of deadbeats and write-offs is accumulating in the banking system. "Debt has melted down corporations' rates of return on assets from the 23% level in the late '50s as low as 6% last year," notes Comstock partner Charles Minter. Even if interest rates tumble, banks may be unwilling to lend, either because they are burdened with defaults or because they deem customers uncreditworthy.
Companies that have used leverage to finance growth will be in the most trouble, because they won't have the cash flow to service it. "Pay down debt and start building cash," Minter urges. "If the pie shrinks, you want to have a company that holds its market share, not one that can't keep up with a larger company with more financial stability." Indeed, a smaller company with its house in order may be able to snatch market share from a larger company, "if that larger company still thinks we're going to grow. One pit bull can take on a lot of big dogs."