Debt-to-Equity Ratio as Fishing Lure

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Includes: CAR, RDDC
by: Dr. Kris

People are starting to bottom fish for companies with low debt on the assumption that they'll be the fastest to rebound once the economy starts to recover. But there is contradictory evidence that it's precisely the debt-laden companies that are seeing the biggest rise in stock price. Today I'd like to delve further into this conundrum and see if we can find some clarity.

The fundamental argument
In an article that appeared on MSN Money on Tuesday, Jim Jubak said that if you want to do some stock shopping, avoid companies that have loaded up on debt such as restaurant chain owners DineEquity (NYSE:DIN) which sports a hefty debt/equity ratio of 10.22 and Brinker International (NYSE:EAT) whose debt/equity ratio is a more modest 1.44. (A debt/equity ratio greater than 1 signals that the company is running more on debt than on equity. Stocks with high debt/equity ratios are considered riskier than those companies with little to no debt especially in rising interest rate environments.)

I like Jim's articles. He does his research and knows his stuff, but apparently he forgot to check the charts. Since the market low on March 9th, EAT has doubled in price while DIN has quadrupled--good thing we didn't buy those stocks!

The technical analysis
A recent CNBC guest commentator said that it was precisely these debt-laden companies that have been the best performers in recent months. Not to doubt the gentleman's veracity, I decided to find out for myself. What I did was to screen for the highest percentage gainers in the past month that were over $2 and traded at least 100,000 shares per day on average. (I used the deluxe screener in MSN Money--it's free!) Out of the 100 stocks that came up, seven of them had no debt/equity listing so I discarded them leaving me with a sample space of 93.

Of those 93, 53 companies had debt/equity ratios greater than one, or 57% of the total. That's not much more than average but it is a lot more than I would have expected especially in this credit environment. And of the 26 companies that had gained more than 100% in value, 15 had debt/equity ratios greater than one, or 58%.

Today's percentage gainer list was even more interesting. The top two stocks were Avis/Budget (NASDAQ:CAR), up 22%, and Reddy Ice Holdings (FRZ), up 18%. Are they low-debt companies? Hardly. The ratio of debt to equity for Avis is 84.11 which is high even by industry standards (6.18 on average). Even more incredible is that the same ratio for Reddy Ice is an astronomical 450.76, the highest of ALL stocks over $2. I mean, all they do is sell packaged ice, for crying out loud. I don't get it. I can only scratch my head as to why an ice company is topping the list—could this be a play on global warming?

Conclusion
The point to take away here is that it seems as if investors are ignoring conventional wisdom and valuing other aspects of the business besides some numbers on a balance sheet, and to me, that's what really makes sense. But if you want to bait your hook with the debt/equity ratio, I'd use the one that will snag the high-debt fish.

Here's a chart (click to enlarge) showing how you would have done over the past month had you bought an equal dollar amount of the each of the top 25 debt-laden companies:



Did you see that there were only 5 losers?

Here's the stock move Jim Jubak missed (click to enlarge):