High Debt Anomaly
The Barrons is a pretty useless publication due to its editors perma bear stance. They should just fire Alan Abelson, he has been consistently and irrationally bearish for much of his editorship plus his cognitive bias has made the publication pretty useless for serious speculators . So I do not subscribe to it, but last week I was going through the past issues at the library as part of the year end review and I found one interesting anomaly about high debt companies. Now this is the kind of information which is useful fodder to think about. The link requires subscription.
EXTRA RED ON A COMPANY'S BALANCE SHEET can mean more green in a stockholder's pocket. That's the surprising conclusion of a study of corporate debt ratios and stock prices by Narasimhan Jegadeesh, finance professor at Emory University's Goizueta Business School, and Clifton Green, associate professor at the school. After examining all publicly traded nonfinancial companies from 1974 to 2005, they found that companies with high debt levels relative to their peers boast superior stock-market returns.
EXTRA RED ON A COMPANY'S BALANCE SHEET can mean more green in a stockholder's pocket. That's the surprising conclusion of a study of corporate debt ratios and stock prices by Narasimhan Jegadeesh, finance professor at Emory University's Goizueta Business School, and Clifton Green, associate professor at the school. After examining all publicly traded nonfinancial companies from 1974 to 2005, they found that companies with high debt levels relative to their peers boast superior stock-market returns.
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Yes, I read that article in one of last month's issues.
Interestingly, a company that I worked for listed on NYSE had plenty of cash but decided it would rather go into debt than dig into its reserves. Much of this company's revenue came from new acquisitions. It seems that those companies that keep plenty of cash on hand, and may need to go into debt, are able to pounce on opportunity faster than their debt-less competitors. It may be that the time value of money is the major factor here.
It's all about the sentiment. If a company has high debt levels relative to peers, it will probably pay the debt down and get a sentiment boost. If a company has no debt, or low debt relative to peers, when it uses debt it will be hammered by the sentiment of the market.
More than that if you have high debt you have high leverage on profitability side. Look at airlines and some transport companies.
Leverage works both ways, in bad times the high debt company gets hammered more than the low debt company. Since the study was multi-decades, I would assume it went through both good and bad times for every industry and the effect of leverage should have evened out. I don't think that was it, but what do I know?
Another aspect of sentiment: if a company has high debt, they probably recently took on that debt! Acquisition or whatnot. So their stock price has probably been punished by "Mr. Market" for the expense, setting the stock up for a long-term mean-reversion play.
Fidelity has a fund Leveraged Company Stock fund which I have it in my long term retirement acounts. It is up 17% this year and has one of the best returns for last 3 years. It uses exactly similar strategy.
FLVCX
What it is
A domestic equities mutual fund.
Goal
Seeks to provide capital appreciation.
What it invests in
Normally investing at least 80% of assets in stocks. Normally investing primarily in common stocks of leveraged companies (companies that issue lower-quality debt and other companies with leveraged capital structures). The fund may also invest in lower-grade quality debt securities and it may buy 'growth' stocks or 'value' stocks, or a combination of both types. Investments in smaller companies may involve greater risks than those in larger, more well known companies. Leverage can magnify the impact of adverse issuer, political, regulatory, market, or economic developments on a company. A decrease in the credit quality of a highly leveraged company can lead to a significant decrease in the value of the company's securities. In the event of bankruptcy, a company's creditors take precedence over a company's stockholders. Non-diversified funds tend to be more volatile than diversified funds. Although the companies that the fund invests in may be highly leveraged, the fund itself does not use leverage as an investment strategy. Share price and return will vary.
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