Does Debt Financing Affect Future Stock Price Performance?

|
 |  Includes: AKAM, ANF, BIG, CMG, CPWR, DV, EA, FAST, FFIV, FLIR, GME, GOOG, LSI, NVLS-OLD, PCP, PWR, RHT, TDC, TLAB, URBN, WDC
by: Kurtis Hemmerling

Academics continue to struggle with the problem of linking fundamentals to stock price performance. CAPM was able to explain roughly 70% of price movements using beta. Fama and French improved that number to 90% by including market cap and book value. Other methods that use factor loadings include price to earnings, price to book, and price to dividends.

One branch that hasn’t received a lot of attention is debt levels which relates to financial leverage. Can the amount of financial leverage a company has lead to future excess gains in the market?

Modigliani and Miller (MM 1958, Miller 1977) claim that the market value of any firm is independent of capital structure. They further propose that the “expected rate of return…on the stock of any company…is a linear function of leverage”. When you factor in taxes (1977), this effect might go away leaving debt and equity financing the same. Does it really make no difference whether a company is equity or debt financed?

One retort to this is an abstract that came out in October 2010 called, Would You Follow MM or a Profitable Trading Strategy?, by Brian Baturevich and Gulnur Muradoglu. They attempted to find a link between capital structure and future gains showing that debt does matter.

What did their empirical data find?

Debt, Equity, and Stock Returns

The setup for the test uses S&P 500 stocks. They remove financial stocks which account debt differently. Also, some new stocks were removed leaving 413 companies to be tested over 20 years, from 1985 – 2004. They analyzed the capital gearing ratio, and filtered these with other metrics to see which companies could achieved the largest results.

What they found was contradictory to Modigliani and Miller. Low-debt companies outperformed high-debt companies. The benefit for financial leverage was not generally observed. They grouped companies according to their financial leverage into 10 portfolios. These are the excess gains (over and above the market) over 3 years time.

  • Decile 1 = 17.1% (Lowest gearing or debt)
  • Decile 2 = 14.7%
  • Decile 3 = 6.2%
  • Decile 4 = 6.7%
  • Decile 5 = 4.3%
  • Decile 6 = 2.2%
  • Decile 7 = 1.6%
  • Decile 8 = -2.8%
  • Decile 9 = -7.1%
  • Decile 10 = 8.4% (Highest gearing or debt)

I found it odd that the highest debt leveraged company did have market excess gains. Perhaps it had something to do small companies aggressively expanding that must rely on debt financing to grow? More work is needed to investigate this finding.

They found a further benefit for smaller companies with low-debt. These were able to outperform the market with over 80% excess gains in a three year period.

Creating the Scan

I am tempted to try this on the entire universe of stocks, however their pool was only the S&P 500. This is the criteria:

  1. S&P 500 index
  2. Market Cap under $10 billion
  3. Long-term debt to equity under 0.1
  4. Debt to equity under 0.1

Low Debt Stock List

Ticker

Company

Industry

Market Cap

FAST

Fastenal Co.

General Building Materials

9861.59

TDC

Teradata Corporation

Diversified Computer Systems

9343.94

WDC

Western Digital Corp.

Data Storage Devices

9141.7

RHT

Red Hat, Inc.

Application Software

9121.22

CMG

Chipotle Mexican Grill, Inc.

Restaurants

8311.53

FFIV

F5 Networks, Inc.

Application Software

8090.34

MMI

Motorola Mobility Holdings, Inc.

Diversified Communication Services

7459.54

ERTS

Electronic Arts Inc.

Multimedia & Graphics Software

6786.7

AKAM

Akamai Technologies Inc.

Internet Information Providers

6416.76

ANF

Abercrombie & Fitch Co.

Apparel Stores

6198.56

FLIR

FLIR Systems, Inc.

Aerospace/Defense Products & Services

5624.14

URBN

Urban Outfitters Inc.

Apparel Stores

5167.98

PWR

Quanta Services, Inc.

General Contractors

4553.17

LSI

LSI Corporation

Semiconductor - Specialized

4516.44

DV

DeVry, Inc.

Education & Training Services

3671.8

GME

GameStop Corp.

Electronics Stores

3627.25

TIE

Titanium Metals Corporation

Industrial Metals & Minerals

3520.52

BIG

Big Lots Inc.

Discount, Variety Stores

3105.01

NVLS-OLD

Novellus Systems, Inc.

Semiconductor Equipment & Materials

2792.37

CPWR

Compuware Corporation

Application Software

2465.43

TLAB

Tellabs Inc.

Communication Equipment

1704.69

Click to enlarge

Of course, smaller companies without debt in the S&P 500 is not an exhaustive approach to investing. But it is a strong beginning which can be refined. While the results were not particularly strong when this strategy was mixed with book value, beta, or PE ratios, there are other approaches that could be used.

1. The two companies with the lowest PEG ratios are GME and NVLS. Note that GameStop has made a good run since March and is currently in a pullback. NVLS, on the other hand, has slumped heavily since March. NVLS is still expected to grow earnings 17.5% this year and average 13% annually over the next 5 years, but the downward revised forecast disappointed. It may very well be entering bargain territory for investors that don't believe in an efficient market.

2. If you are a momentum investor that believes positive past 52 weeks of returns help generate future excess returns, then no doubt you will want to check out TDC and BIG.

3. If you like to play it dangerously and comb stocks trading near their 52 week lows, then you may want to analyze the risk/reward scenario with TLAB. It’s not my thing but I know it is quite popular with many contrarian investors who are adept at spotting turnarounds.

To be clear, just because a company has low debt and is smaller, you should not run out and invest in it. But according to the abstract quoted here, it might be a good first filter to run -- an alternative to the Fama and French method of small value stocks.



Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.