Big Debt and Big Returns Could Be Spurring This Rally

I shared an observation yesterday regarding the rally in March: A lot of the performance in the S&P 500 is being driven by mean-reversion, with some of the biggest losers over the past year showing the strongest returns in the rally. I demonstrated that there was generally a correlation for companies with better balance sheets (measured by net debt to capital) to show better performance with the strange exception of some of the best performance to have come from stocks with among the worst balance sheets.

In this follow-up, I want to dig a little deeper on that front. As you can see in the chart below (click to enlarge), I sorted the entire S&P 500 by net debt to capital using StockVal, dividing it into deciles. I then plotted the returns of each of the 50 members of each of the deciles, with the lowest decile (on the left) representing the strongest balance sheets:

Looking from this perspective, we arrive at the same conclusion: The highest decile (the worst balance sheets) produced some of the highest returns (as did the second decile). Otherwise, there was generally a tendency for most of the returns in a decile to be higher as we move to the left (towards better balance sheets).

Here are the stocks with returns >40% so far in March by decile:

• Worst Decile: Bank of America (BAC), Citigroup (C), E*Trade (ETFC), General Motors (GM), Advanced Micro Devices (AMD), CB Richard Ellis (CBG) and Ford (F)
• 2nd Worst Decile: American International Group (AIG), MBIA (MBI), and International Paper (IP)
• 3rd Worst Decile: Goodyear (GT)
• 4th Worst Decile: Rohm & Haas (ROH), Whirlpool (WHR), Masco (MAS), and Harley-Davidson (HOG)
• 5th Worst Decile: Hartford (HIG), Centex (CTX) and AutoNation (AN)
• 5th Best Decile: KB Homes (KBH), Janus (JNS), Lennar (LEN) and JC Penney (JCP)
• 4th Best Decile: Whole Foods (WFMI) and Torchmark (TMK)
• 3rd Best Decile: Genworth (GNW)
• 2nd Best Decile: XL Capital (XL), Ciena (CIEN), Sandisk (SNDK) and JDS Uniphase (JDSU)
• Best Decile: Sun Micro (JAVA)

As I review these names, I have to be careful and not say them out loud. If I do, I am sure my beagle will howl as she tends to do when she sees other dogs. In many cases, these stocks were very oversold no doubt, but I don't believe that we can count on a repeat of this type of performance from this cast of characters. To reiterate my conclusion yesterday: Use this rally to improve the quality of your portfolio by paring companies with strained financials.

Disclosure: None

Comments

[the_feds_co...:]

How about MASSIVE FRAUD BY AIG AND ITS PARTNER BANKS! There is no rally its a massive lie!
Tell the truth if u dare!

Mar 30 03:14 AM

[Zoltan L. K...:]

Great analysis. The question is, how long this "counterselection" will keep on?

Mar 30 03:40 AM

[balabanovj:]

Debt/equity ratios are but one measure. In general, Alan is right, but in the case for example of Bank of America, we're all pretty sure how the story is going to end. It might take a few years, but BAC is going to extinguish it's TARP debt in the next 12-18 months as per it's CEO, and from there, at least if we are in the midst of an economic recovery, it's clear sailing and BAC will once again be an enormously profitable company- even moreso this time with it's ML investment arm which will add revenue through brokerage and IB, and Country Wide to take advantage of the real estate recovery. My prediction is that CW will eventially be spun off after BAC has milked the recovery out of them. BAC though, will return relatively quickly to EPS levels of at least $5-6/shr and a $50 share price.

JBB

Mar 30 04:25 AM

[Alan Brochs...:]

While I am not to sure I agree with you, I am more sure that your comment will provoke lots of disagreement. BAC could have the rosy future you depict, or it could end up being diluted away. That CEO you cite might not be there before this crisis ends.


On Mar 30 04:25 AM balabanovj wrote:

> Debt/equity ratios are but one measure. In general, Alan is right,
> but in the case for example of Bank of America, we're all pretty
> sure how the story is going to end. It might take a few years, but
> BAC is going to extinguish it's TARP debt in the next 12-18 months
> as per it's CEO, and from there, at least if we are in the midst
> of an economic recovery, it's clear sailing and BAC will once again
> be an enormously profitable company- even moreso this time with it's
> ML investment arm which will add revenue through brokerage and IB,
> and Country Wide to take advantage of the real estate recovery. My
> prediction is that CW will eventially be spun off after BAC has milked
> the recovery out of them. BAC though, will return relatively quickly
> to EPS levels of at least $5-6/shr and a $50 share price.
>
> JBB

Mar 30 06:13 AM

[CautiousInv...:]

Many of the companies with the highest debt structure are outpacing the market for the simple reason that investors believe Treasury, through CAP and the recently announced PPIP to purchase legacy assets and securities, will improve their debt and capital structure. In the eyes of some, they are not as bad as they look.

Mar 30 07:50 AM

[Econ 101:]

Imagine a Tsunami...first there is an earthquake you dont see (the Guinther-AIG fraud), then the water pulls back (this "rally"), finally the wave crashes over those who were foolish enough to run in to collect all the pretty shells exposed by the pull back.

Mar 30 10:13 AM

[Pj568:]

It will be difficult for any financial services company to return to prior levels just due to the change in basic fundamentals underway. Several have had to: issue additional stock, are decreasing their own leverage ratio's, decreasing leverage of their customers and eliminated dividends. That's a big load to overcome with their history of settling for ROA's of less than a percent.

Mar 30 10:56 AM

[Ricard:]

I don't think CIEN deserves to be lumped with this crowd. I sold JDSU to add to my CIEN stake due to better financials, both income statement and balance sheet-wise. Fact is, it was posting a healthy profit before July of last year for a good six straight quarters, and given those earnings figures, is a downright steal at these prices. This translates to a full recovery from the dot-com bust IMHO. It has enough CASH on hand to retire its debt if it so chooses, but otherwise has years before its next maturity in which to weather this storm. It's holding quite well compared to competitors such as Nortel or ALU - the last earnings statement corroborates this viewpoint.

I realize that it's in your 2nd best decile of balance sheet performers, but I don't think it deserves to be lumped in a crowd to include BofA, Citi, and MBIA.

Mean reversion for this stock should be around $2/share pre-reverse split, or around $15. That would take it to the low that it reached in the dot-com bust, when it was hemmoraging capital. Tertiary industries such as Ciena's have been unduly hit by the outflow of capital in the past year.

Mar 30 01:53 PM

[Alan Brochs...:]

I agree - CIEN isn't a dog relative to the others mentioned...

Mar 30 03:21 PM

[tclwrap:]

I would not doubt if BAC would get broken down into smaller units, after the new regulations... Too big to fail is the key reason why it should be broken up.

Apr 01 01:53 AM