Imagine a time when it is easy to borrow money at extremely low rates. The supply of capital is abundant. I know it’s hard to imagine nowadays but these sorts of environment do emerge time to time, a time when anyone with the hold of idle money is ready to supply the capital in exchange of whatever small return possible. Many supplier of capital also seek risky ventures. Suddenly, their risk appetite go up.
New businesses form. Many of the existing businesses load up debt. They increase the capacity to serve wider market ignoring the fact that their competitors are doing the same thing and the market can only consume a fraction of the increased supply. They cut prices and are okay to do business at low margins. Now, the hurdle rate is low. Earn a low return, because you can finance it at low rate.
Most businesses spend lavishly because it’s the boom time. The businesses that have been avoiding too much debt is now at the mercy of the expansionists. They don’t load up debt or overspend because they know easy times don’t last forever. Easy time is followed by hard times.
During easy times, ‘unnatural selection’ happens (borrowed the term from the book: Price of Time). Weaker ones also get the space to play. The fittest ones survive in the crowded market but take their time to thrive.
When the tables turn and capital becomes short in supply, hurdle rates go up. Only the fittest ones who saved their energy can jump above the line. The weaker ones disqualify. ‘Natural Selection’ sets its order again. Now is the time for the fittest one to thrive.
Easy time doesn’t only mean low interest rate. It also means the absence of or relaxed rule of law, when businesses can find means to bypass the law and compliance to do whatever they want.
During easy times, maintaining low debt to equity ratio and preserving the spending discipline seems like a conservative approach. But the same strategy turns out to be smart move during hard times.
Fittest ones thrive during hard times.