John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
'Creative Destruction." It's not just a great name for a heavy metal band, it's also a critical concept in economics and investing. The Austrian economist Joseph Schumpeter coined the term as a way to describe how a capitalist system's incessant competition creates a cycle in which existing economic structures are destroyed and replaced with new, more efficient ideas and ways of doing things.
Creative destruction is usually everywhere. Just look at the continual culling of unsuccessful businesses from the marketplace. Since 1980, more than 320 companies have been removed from the S&P 500 for "business distress" reasons, according to a recent JPMorgan report. "This should not be a surprise: Capitalism is based on competition, creative destruction and reinvention," JPMorgan's Michael Cembalest wrote in the report. "While globalization … expanded the opportunities for individual companies, it also increased their competitive, regulatory and operational risks."
In recent years, however, a wrench has been thrown into creative destruction's wheels: the Federal Reserve's ultralow interest rate policy and quantitative easing efforts. With the cost of capital so cheap, a number of companies that normally would have been pushed out of business or into serious trouble by competition or mismanagement have used cheap debt to stay in the game. It is likely that these firms will stay afloat for some time, as the dovish Fed seems highly unlikely to engage in a rapid-fire, major increasing of rates.
But the easy money won't last forever. At some point, the cost of capital will rise to the point that struggling businesses won't be able to bail themselves out by borrowing. Creative destruction will once again reign.
Don't wait until that happens to clear your portfolio of low-quality, debt-laden companies. I have studied the strategies used by history's most successful investors for over a dozen years and one of the main themes I've found is that these investors steered clear of overleveraged companies because they knew that firms that rely on high levels of debt to stay in business eventually run into big trouble. Low debt is actually the most common attribute across the 12 guru-inspired strategies I use in my investment portfolios.
With that in mind, here is a look at some of the companies that have increased their debt-market capitalization ratio the most since the easy money started flowing in 2008, and some that have decreased their debt load the most over that time frame.
One of the big debt-increasers: Web.com Group (WWWW-Nasdaq), which provides a range of Internet services to small businesses. The firm, with a market cap of $1-billion (U.S.), has a debt/equity ratio of 285 per cent, and it also fails a key debt metric that my Benjamin Graham-inspired model uses. Mr. Graham, known as the father of value investing, wanted a company to have at least as much in net current assets as it did long-term debt. Web.com has more than $450-million in long-term debt and its net current assets are actually negative (minus $140-million).
On the other side of the coin, there is natural and organic grocery store chain Whole Foods Market (WFM-Nasdaq). Whole Foods is among the firms with the biggest declines in debt/market cap since 2008. Currently the firm has a debt/equity ratio below 2 per cent and more than nine times as much net current assets as long-term debt. Its low debt, 23 per cent long-term earnings-per-share growth rate, and reasonable 18.6 price/earnings ratio make it a favourite of the model I base on mutual fund legend Peter Lynch's approach.
My strategies are nowhere near as keen on CF Industries Holdings (CF-NYSE), a nitrogen fertilizer maker that finds itself on the list of companies with the biggest debt/market cap increases. CF has more than $4.5-billion in long-term debt, and just $613-million in net current assets. Its debt-to-equity ratio is over 110 per cent.
While a number of retailers have loaded up on debt in recent years, Dick's Sporting Goods (DKS-NYSE) makes its way onto the list of biggest debt/market cap decliners. The Pennsylvania-based firm ($6-billion market cap) has just $5.6-million in long-term debt versus $714-million in net current assets. Dick's, which has a 20-per-cent return on equity and trades for just 0.8 times sales, gets high marks from both my Lynch- and James O'Shaughnessy-inspired models.
Keep in mind that debt in and of itself is not a bad thing. Smart managers use moderate amounts of debt to upgrade facilities, make acquisitions, or do other things to grow their businesses. But at a certain point, debt becomes dangerous. If a company is relying on debt just to maintain its current operations, or debt – and not organic growth – is the key force behind earnings growth, the company may well be operating on borrowed time. Those are not the type of businesses you want in your portfolio.