Debt isn’t always the dirty word stock investors think it is. Some of the most successful investors over time have used debt to buy cheap companies, nurse them to health and reap the gains.
Private-equity firms try to capitalize on debt to reap profit. They snap up struggling publicly traded companies, with the help of some debt financing, spend a few years turning them around by restructuring or shedding businesses and then they sell them back to public stockholders, ideally at a gain.
That isn’t to say all debt is good, either, of course. Debt-laden companies pay more for their credit, and those interest payments take money away from shareholders. They have a higher default risk and face higher interest rates if they fall behind on their loan payments.
Warren Buffett has said that debt is one of the factors that speaks negatively about a stock. That’s because long-term debt is vulnerable to increases in interest rates that can affect the predictability of future cash flows.
But most leveraged buyouts are of smaller companies, according to research by Dan Rasmussen, a former private-equity analyst who now runs the hedge fund Verdad. And these deals don’t all go sour.
Mr. Rasmussen and colleague Brian Chingono used decades of research on small-company stocks to show how investors can benefit from leveraged small companies.
The goal is to identify the cheapest stocks of companies that are strong enough to repay their debt. For publicly traded companies, the ability to pay down debt over time using the cash generated by the business can result in investors giving the firm higher valuations as bankruptcy risk falls and as interest payments from lower debt levels decline.
Based on all of this, the researchers found that the ideal leveraged small stock could be uncovered by looking at factors such as gross profit-to-assets, long-term debt-to-assets, valuation as measured by enterprise value-to-gross-earnings and long-term debt-to-enterprise value.
The average annual return of the top quartile of the stocks that passed their screens was 25.1 per cent.
One warning for investors: The stocks that score well on this model have a high degree of volatility, especially to the downside. Excess risks are rewarded with excess returns, but this heightened volatility is something to consider for risk-averse types.
Validea analyzed the model and found that the returns of the past few years have not been as high as those tested in the research paper, which covered ground from the 1960s to 2013.
The performance from 2006 to 2017 puts the portfolio just above the middle in terms of long-term performance. But that is also in keeping with the trend in the market over the past five years that has favoured large-cap and growth stocks over smaller-cap and value models.
Here are some of the stocks that came out on top when Validea used the screens suggested by Mr. Rasmussen and Mr. Chingono:
Marcus Corp. (MCS-NYSE) – An operator of multiplex cinemas. It has a debt-to-equity ratio of 0.7 and a relatively low 9.1 enterprise value/EBITDA (earnings before interest, taxes, depreciation and amortization). EV/EBITDA is used because it presents a way to take the firm’s level of debt into consideration when valuing the company. Earnings for Marcus, while choppy, have been positive in each of the past 10 years.
Lannett Co. (LCI-NYSE) – This generic-drug maker has an EV/EBITDA ratio of 5.6. The stock trades close to its 52-week low. A big research development can turn a company such as this one into a cash machine if management gets it right.
Seaspan Corp. (SSW-NYSE) – This company owns and manages container ships. It has a P/E of 7.3 and EV/EBITDA ratio of 6.8.
Encore Capital Group (ECPG-Nasdaq) – This debt-recovery firm has EV/EBITDA ratio of 11.6 and tons of debt. Yet, earnings have been increasing nicely over the past decade and the firm has a return on equity of 14.8 per cent.
Gray Television (GTN-NYSE) – This broadcaster has an EV/EBITDA ratio of 7.7 with very healthy returns on capital and equity.
To be sure, the majority of the models created by Validea screen for companies that have lower debt levels, but as this research points out, looking at debt through another filter may unearth some hidden opportunities.
John Reese is chief executive officer of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service