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Many gurus, one lesson: Beware the dangers of debt

There are a myriad of lessons investors can take away from the financial crisis of 2008, but the greatest of them may be this: Excessive leverage is an incredibly dangerous thing. U.S. corporations, institutions, and individuals spent years borrowing more than they could afford, and in '08 it caught up to them in a very painful way.

The lesson of the danger of debt is not a new one. In the decade-plus I've spent studying history's most successful investors, one major theme I've found is that these gurus were very concerned about a company's use of leverage. In fact, almost all of the Guru Strategies I track on my website (each of which is based on the approach of a different investing great) include at least one variable that looks at a company's debt level.

But there's more than one way to look at debt. That's reflected in the variety of metrics the gurus used. The strategy I base on the great Warren Buffett, for example, compares a firm's debt to its earnings. It likes a company to have enough annual earnings that it could, if need be, use those earnings to pay off its debt within five years (preferably two).

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The approach I base on the writings of Benjamin Graham - Buffett's mentor - looks, meanwhile, at debt in relation to a company's assets. It requires that a firm's net current assets, or "working capital," be no less than its long-term debt. This essentially tells you whether a company could liquidate its assets today and have enough to pay off all short-term liabilities and long-term debts.

Several other gurus upon whom I base my models used the debt/equity ratio to assess a company's balance sheet. But even among them, the methods differed. Some, like Peter Lynch, used a fixed debt/equity target. In Mr. Lynch's case, he usually wanted the ratio to be no greater than 80 per cent for non-financial firms.

Others, however, used debt/equity standards that weren't pegged to a particular number. Martin Zweig, for example, found that companies in different industries tended to carry different levels of debt, which made it ineffective to use a single standard. He thus wanted a firm's debt/equity ratio to be below its industry average.

Joseph Piotroski, meanwhile, was more concerned with the direction a company's debt was going. He wanted a firm's long-term debt/assets ratio to be declining or staying the same in the most recent year, compared to the prior year. It didn't matter whether the firm had a long-term debt/assets ratio that was 5 per cent or 100 per cent; if the debt level was increasing, he viewed it as a negative.

So, which debt measurement is best? There's no right answer to that question. Each of the gurus excelled using their own strategy, and since each used a variety of other variables to pick stocks, it's hard to pinpoint whose debt criteria worked best over the long run. But I think the key lesson is of a broader nature - that investors need to look at a company's debt level and balance sheet in some way before investing in it. Otherwise, you run the risk that the firm is propping up earnings in the short term by using excessive leverage - leverage that could end up being a major drag on the firm in the future.

Currently, with companies having cut costs and streamlined operations in the wake of the financial crisis, it's not too hard to find firms with solid balance sheets - good news for investors. Here are a few that have recently caught my models' eyes.

Cameco Based in Saskatoon, Cameco's mines in Canada and the U.S. account for about 16 per cent of the world's uranium production. The firm has a solid balance sheet, with about twice as much in net current assets as long-term debt, and a debt/equity ratio (21 per cent) that is less than half its industry average. That debt/equity ratio is part of the reason my Lynch-based model likes the stock. It also likes that Cameco's price/earnings ratio (12.3) is about half of its 24.4-per-cent long-term earnings per share growth rate. (I use an average of the three-, four-, and five-year EPS growth rates to calculate a long-term rate.) That's a sign the fast-growing firm's shares are a bargain.

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Panera Bread This Missouri-based bakery and café chain has close to 1,400 shops in the U.S., and a few in Ontario. It also has a pristine balance sheet - while the average debt/equity ratio in the restaurant industry is about 79 per cent, Panera has no long-term debt, part of the reason my Zweig-based model gives it a perfect 100-per-cent score. This model also looks for companies that are growing earnings at an accelerating rate, and Panera delivers. Its long-term EPS growth rate is 16.2 per cent; in the three quarters leading up to last quarter, that increased to 22.1 per cent; last quarter, it jumped again to 43.9 per cent.

Forest Laboratories This New York-based biotech firm makes medicines and therapies that treat a variety of conditions, ranging from depression to hypertension to Alzheimer's disease. It's a favourite of my Graham-inspired strategy, and a big reason is its long-term debt - it has none. In addition, the firm also boasts a very strong 4.67 current ratio, and it's selling for a reasonable 12.1 times earnings and 1.68 times book value.

Disclosure: I'm long PNRA and FRX.

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