Is there a way Brookfield (TSX:BM) or Brookfield Asset Management (TSX:BAM) could end up disappointing investors?
Motley Fool analysts Jim Gillies and Nick Sciple consider what has the potential to go wrong.
Nick Sciple: You have to do a pre-mortem. A pre-mortem, as in before, before things go wrong, what’s going to go wrong? How does an investment here in Brookfield Asset Management (TSX:BAM) and/or Brookfield Corporation (TSX:BN), do poorly over the next five years? Thoughts.
Jim Gillies: Probably you can summarize the thoughts in one word; that word is leverage. They are not strangers to leverage. They’re not unaware of the benefits of leverage. They’re behind a lot of really cheap leverage to purchase assets and the past decade-and-a-half of zero interest rate policy. So they’ve got a lot of borrowed money out there. And the cost to roll that borrowed money is of course rising recently. Although I see this morning – someone I believe in U.S. government or at least high in the investing world – observing the U.S. government said that the U.S. Fed is done raising for the year, which wouldn’t shock me, frankly. Canada stopped a couple of interest rate hikes go. You guys have done a couple of them since we finished. Probably going to hold out for a while.
But the leverage pressure may be spilling off of the Brookfield entities, but that’s where I would guess if there is going to be a problem, especially with the commercial real estate stuff. I mean, there’s a lot of smoke around that area. If we are working from home and a lot of office towers end up with 35 percent vacancy, that could make people that own our leveraged office towers – it could make it more difficult for them. So that’s where I would go. I’m not sure that I see pre-mortem or post-mortem. I mean, the word death is literally in there. Pre-dead. I don’t think you can kill these companies. I think that’s what a disappointing outlook might look like, Dwight Schrute, if that’s your real name.
I think what it really looks like is stagnant returns, or you might come back in five years and your annualized return is negative five percent while the market has gone up eight percent or nine percent annualized. That would be a disappointing outcome. Not the least of which is because Brookfield is in my top three holdings! But that would be a disappointing outcome. But I’m reasonably certain that this is not a company that implodes on itself from a type of leverage, rather it just struggles and stagnates in the higher interest rate environment or in an environment where people have options, they can go elsewhere for their investment returns. Now the fixed-income market might be a little sexier than it was, say, two years ago.
But that’s where I would look, but I’ve not seen any evidence of that hindering them. Again, these are some of the smartest people in Canadian and worldwide finance. They know how to run a business. They generally have most of their debt facilities, I believe, fairly isolated from one another, so a lot of project-specific debt and that’s everything. There’s of course, all the different tendrils of all the different businesses, so you can pick and choose where you want to invest in the Brookfield empire. But I’m not terribly worried about Bruce Flatt driving this over a cliff. I’ll put it that way. But maybe he disappoints from here.
Nick Sciple: Yeah. Just just a note on the leverage thing and an underline with what Jim said about fixed income has become sexier. What he’s saying is interest rates have increased, and so things like bonds are much more attractive as a potential investment asset for income than they have been in years past because of, again, five percent higher is than two percent. Very simple math there.
When you are competing with a two percent alternative, now you’re competing against a five percent alternative, that’s a harder competition, A. B, use a lot of leverage when it comes to financing some of these assets. So when your cost of capital goes down and the people you’re competing with to get capital flows to you, their returns go up that can potentially create a challenge for the business.
However, one thing that is interesting with Brookfield is, leverage is often the reason you see interest rates going up. Why you’re seeing interest rates going up right now is because of inflation. You’re trying to combat inflation and bring it down, and at least for Brookfield Infrastructure Partners, the vast majority of cash flows are tied to inflation such that their cash flows increase while their debt remains at a fixed rate. If rates go up forever, it’s bad for the company. But if rates go up and stop and their capital structure remains constant, they’re actually can be some tailwinds to the company from increasing inflation because the interest rate bump-ups occur while their debt that they’ve taken out in the past remains at a fixed rate. There’s lots of puts and takes with the company. But essentially if cost of capital goes up and flows go down and flows of capital to the company slow down, that could be a potential headwind for the business. But do I think we’re going to come back in five years and Brookfield isn’t on the shortlist of companies to own in managed infrastructure assets on a global basis? I think it’s very unlikely that that’s going to change.