John Reese is founder and CEO of Validea.com and Validea Capital Management, and portfolio manager for the Omega American & International Consensus funds. Globe Investor has a distribution agreement with Validea, a premium Canadian stock screen service. Try it.
“Do not accustom yourself to consider debt only as an inconvenience; you will find it a calamity,” the English author Samuel Johnson once said. Over the past several years, the financial world has seen just how right he was.
From U.S. home buyers who took on mortgages they had little chance of paying, to governments that piled up mountains of IOUs, debt is weighing like an anchor on borrowers.
I’ve spent more than a dozen years studying history’s most successful investors such as Warren Buffett, Peter Lynch and Benjamin Graham. I’ve found that the most common factor these gurus looked at when buying stocks wasn’t price/earnings ratios or earnings growth rates or returns on equity. It was debt. Of the 11 investing greats upon whom I base my Guru Strategies, at least 9 used debt as a key component of their approaches – the less debt a company carried, the more likely the guru was to invest in it.
That’s not to say that they all used the same exact approach when analyzing debt. Mr. Buffett, for example, has targeted companies that generate enough earnings to pay off all their existing debt within five years (and preferably within two years). Mr. Graham, the man known as the Father of Value Investing, focused on companies whose long-term debt was less than the value of their net current assets. Several other gurus, like Mr. Lynch, used the debt/equity ratio.
The bottom line is that the vast majority of these highly successful investors were leery of companies that carried a lot of debt.
There’s more to buying a stock than just looking at a company’s debt, of course. All of the gurus I follow looked at a variety of different metrics in combination with debt levels. Here’s a look at a few companies in the U.S. and Canada whose light debt loads and strong other fundamentals make them favourites of my models.
Inmet Mining Corp. : Toronto-based Inmet produces copper and zinc and has operations in Turkey, Spain, and Finland. The firm gets strong interest from my Graham-based model, thanks in part to the fact that it has just $17-million in long-term debt. Its current ratio (current assets divided by current liabilities) is over eight – four times higher than the 2.0 target Graham used, a sign that the company is flush with liquidity. Value was also critical for Graham, and Inmet seems to be offering plenty: It’s trading for just 10.7 times trailing 12-month earnings per share.
GameStop Corp. : This Texas-based firm is the world’s largest multichannel video game retailer, with more than 6,600 stores in 17 countries and various online gaming platforms. It has no long-term debt.
GameStop gets very high marks from my Joel Greenblatt-inspired strategy. This approach uses just two variables in choosing stocks: earnings yield and return on capital. While those two metrics might not seem to be debt-related, there’s a bit of a stealth debt measure in the earnings yield figure. That’s because Mr. Greenblatt doesn’t simply divide a stock’s earnings per share by its price; he found that type of simple earnings yield could be distorted if the company had a lot of debt.
So he (and my model) calculates earnings yield by dividing a company’s earnings before interest and taxes by its enterprise value, which includes not only the price of the company’s shares, but also the amount of debt it uses to generate earnings. GameStop has a stellar 24.3-per-cent earnings yield on that basis, as well as a 57.7-per-cent return on capital. Overall, those two figures make it the 12th-best stock in the entire U.S. market, according to this model.
Monster Beverage Corp. : California-based Monster (formerly known as Hansen Natural Corp.) makes a variety of energy drinks and alternative beverages, such as natural sodas, juice blends, and vitamin-enhanced water. It’s been rumoured to be an acquisition target for Coca-Cola Co. (Coke has denied the rumours.) However that turns out, the company gets strong interest from my Buffett-based model, in part because it has no long-term debt. The strategy also likes that Monster has upped its earnings per share in all but one year of the past decade, and that it has averaged a 28.5-per-cent return on equity over that period – a sign that it has the “durable competitive advantage” that Mr. Buffett is known to cherish.
Disclosure: I own shares of Monster.