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.
In the wake of the Fed summit meeting at Jackson Hole, Wyo., where all antennae were up for any inkling of a rate hike, there's a natural tendency to ponder the effects that an uptick in rates might have on the market. It's important, however, to go a step further and consider the potential long term fallout for those businesses that may have loaded up on ultra-low cost debt.
In Berkshire Hathaway's 2001 annual letter to shareholders, Warren Buffett wrote: "After all, you only find out who is swimming naked when the tide goes out." While many companies have been able to take advantage of low rates to pay down and/or consolidate higher cost debt, reduce interest costs and (perhaps) buy back stock or make acquisitions, a rise in rates could take the tide out and make things drafty for some of the more highly leveraged businesses.
A wall of maturities
Jeffrey Gundlach, DoubleLine chief executive and chief investment officer, has been on record saying there is a "wall" of maturities coming due in just a few years. In a Barron's interview in late 2015, Mr. Gundlach said "hundreds of billions" of corporate and high-yield bonds will be coming around 2019. If interest rates are increasing during debt rollover periods, investor demand for bonds could wane and both bond holders and the companies who have depended on low rates could be in for a big surprise. While Mr. Gundlach's warnings apply to a few years out on the horizon, other mindful thinkers are sounding alarm bells around use of debt in today's market as well.
The market's 'kryptonite'
Aswath Damodaran, professor of finance at New York University's Stern School of Business, characterizes debt as a "sword" and equity as a "cushion." He argues that while debt can allow a company to invest in its future and even instill discipline in management, too much leverage can paint a business into a precarious corner. In a rising interest rate environment, he believes, additional debt costs can whittle away profits and reduce management's flexibility. This idea is reflected in my stock screening model based on Mr. Buffett's investment strategy which takes total debt into account when calculating returns. The underlying philosophy is that, even if a company shows robust return-on-equity figures, too much debt can strain the underlying business. Therefore, our model requires return-on-total-capital (net earnings divided by total debt plus equity) to be at or above 12 per cent.
A recent article in The Wall Street Journal speaks to the issue of how ultralow interest rates have also led to an unsustainable situation in which cash outlays to investors are surpassing corporate earnings. The article quotes Prof. Damodaran as saying that, for the first two quarters of this year, S&P 500 companies collectively returned 112 per cent of their earnings through buybacks and dividends – "the highest level since 2008 and well above the 82 per cent average over the past 15 years."
While many investors are only too happy to be on the receiving end of high dividend payouts and share buybacks, Prof. Damodaran sees this as not only unsustainable but as a key component of what he terms the market's "kryptonite." In a recent blog, he writes: "My biggest concern … is the sustainability of cash flows. Put bluntly, U.S. companies cannot keep returning cash at the rate at which they are today."
Cash flows to equity holders come from earnings after interest expense, dividends and buybacks. Given what the WSJ article highlighted as the S&P 500's "four consecutive quarters of shrinking profits and tepid sales," it doesn't take much accounting prowess to see the risk that higher interest rates presents to highly leveraged companies.
The guru-based strategies I have developed and used for more than a decade include many debt-related metrics. (Investing "gurus" include Mr. Buffett along other prominent investors such as Benjamin Graham, Peter Lynch, James O'Shaughnessy and star Joel Greenblatt.) The table below provides a list of companies (with market caps of at least $1-billion U.S.) that carry little or no long-term debt and score well under at least two of our stock screening models.
Of the names listed, those that get the highest scores from my strategies are:
Dril-Quip (DRQ) designs, manufacturers, sells and services engineered offshore drilling and production equipment. The stocks scores highly based on our Graham value model, which like the company's financial position and the stock's low valuation.
Sanderson Farms (SAFM), a poultry processing company, earns high marks from our Lynch-based investment strategy based on its favourable price-to-earnings-growth ratio of 0.45 and growth in earnings-per-share (three-, four- and five-year average) of 34.0 per cent.
Facebook (FB): The social-media behemoth earns high marks under Validea's Momentum model due in part to a more than doubling of quarter-over-quarter earnings per share and annual earnings growth (over the past five years) of 49.4 per cent. The current stock price is comfortably within the 52-week high, which this screen views as a plus.