In the search of good value we must be willing to take necessary risks. We must be willing to bet on struggling companies, sometimes with bad management, sometimes in struggling industries. However, we must never combine those three things. Most important of all, we must shun excessive debt like the plague. While I prefer to avoid companies with significant debt, in cases in which the company has consistent earnings and the ability to maintain those earnings (because of strong brands or monopoly status), debt is forgivable.
For companies with tough competition and little competitive advantage, debt is a very, very bad idea. Two great cases in point are Movie Gallery (MOVI) and General Motors (GM). Both companies have historically strong brands and decent business models. They are both extraordinarily cheap, and if they had less debt they would be great companies to buy. Saddled with debt, however, they lack the ability to survive their cut-throat industries.
Movie Gallery is a great example of stupid management harming a company. The company’s stock traded as high as $30 in 2005 - it now trades at $4. Movie Gallery runs a chain of video rental stores which historically, have been profitable. However, early in 2005 the company took on much debt to buy Hollywood Video. The company now has a market cap of $130 million, and debt of $1.1 billion.
I would argue that the movie rental business is one of the best businesses to be in. People like watching movies, new movies cost a lot to see at movie theaters, and the competition (satellite and cable movies on demand) are not that great. While Netflix (NFLX) has made it harder for bricks and mortar stores, I feel its impact has been drastically over-rated. I subscribe to the Netflix service, but there are plenty of people who do not. A bricks and mortar store can do good business because those that rent less frequently will not subscribe to Netflix.
Therefore, I think that Movie Gallery’s two chains, Movie Gallery and Hollywood Video, will still be around in one form or another fifteen years from now. The problem is that the debt of the current company will likely result in bankruptcy, and leave the stock worthless.
General Motors faces a similar problem. Unfortunately for the careless investor, its full debt his hidden in details in the company's financial statements about its union contracts and the number of retirees for whom the company provide pensions. Some have estimated that GM will have to pay out over $70 billion in pensions and health care benefits to its current and future retirees. For a company that has consistently lost a few billion dollars per year over the last few years, this is a problem.
In addition to its debt, GM has too many brands, too much production capacity, an unfavorable union contract, and shrinking sales. Without such a sizable debt, GM would stand a chance of restructuring and saving its stockholders. As it stands, it has no room to maneuver. Unless it can become highly profitable within a year or at most two years, it will go bankrupt.
So does debt matter for stock returns? Yes, at least according to “Predictability of UK Stock Returns by Using Debt Ratios” by Muradoglu and Whittington (scroll down on the page to which I link to download the PDF). While the data is from the U.K., the results are logical, and should apply in the U.S. as well. While the correlation of debt ratio with stock returns is lower than the correlation of P/E with stock returns, there is still a definite negative correlation: the stock of those companies with the least debt did the best.
The 30% of companies with the lowest debt showed a consistent advantage over those with higher debt. Those companies had gearing ratios (leverage ratios for you Americans) of under 20%, meaning that total debt represented less than 20% of enterprise value. There are other ways of reporting leverage, but I like this one. In comparison, MOVI has a gearing ratio of 89%, while GM has a gearing ratio of 96%.
Disclosure: I have no position in any company mentioned. This was originally written two years ago and published elsewhere. Movie Gallery has since declared bankruptcy.