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When debt can be good in picking stocks (yes, I just said that)

Recs

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August 29, 2009 – Comments (13)

In this blog I am going to take a look at situations where a company having a considerable amount of debt can be advantageous for investors.  I'll present two basic principles of why this can be so. 

The first principle is market sentiment related:  the market prices debt very negatively, (and, conversely, prices cash on a balance sheet very positively).  Imagine two companies with identical p/s's p/e's book value/share, etc.  Book value for each stock is 10, lets say.  One has $10/share in debt, one has $0 debt and $3 of cash.  It seems to me, from my observations of the markets pricing of stocks, that the company with debt may be priced at $6 while the other may be priced at $15.  

In essence, imagine that Wall Street values $1 on a balance sheet as worth 3 bucks, while $1 of debt on a balance sheet is worth negative 50 cents or something.  It seems, strongly, to me that Wall Street prices debt quite negatively and cash very overly positively.  The good reasons for this are many.  A company with no debt and cash is more recession resistant, shock resistant, possibly more able to invest and grow, etc., etc., etc.  

So principle #1:  its well established that the biggest money is made buying things that are out of favor, because being out of favor produces favorable pricing, as in out of favor produces cheap stocks.  Debt is intrinsically out of favor while cash is intrinsically in favor.  This produces one reason why companies with debt, as investments, may have (at times, there are of course times when debt is crushing, which we'll cover later) an advantage.  

 

And now here's principle #2:  fully manageable debt provides built in earnings growth.  Like this:

Company X has $5 billion of revenue, $500m of cash flow, $250M of profits, and a market cap of $2B, and $2B of debt.  It pays down debt at a rate of about $100m per quarter.  Lets assume that business never improves and stays flat for 5 years.  In year 1 it makes $250M.  In year 2 it has only $1.6B of debt because it paid down $100M/quarter.  So in year 2 it has $400m*8% less interest, or $32M interest, earnings would now be $282M.  Cash flow would also improve... and they could pay down debt that next year to $1.17B.  Saving an additional $35m of interest, earnings rises to $317M.  The next year?  $350M.  The next year?  $385M.  The next year?  etc, etc, etc, etc, etc.  They'd top out at $410m of profits without any actual growth.  And ...

And principle #1 would come into play as they moved from a company that is priced too low because of debt to a company priced more favorably due to low debt.  

The stock could easily double without any improvement.   $2B for a p/e of 8 when it had debt.  And perhaps $5B for a p/e of 12 when it was debt free (higher earnings due to the paying down of debt and a higher multiple due to now being a "low-debt" company). 

 

Now, there are of course very well documented risks to debt.  A company could violate a covenant, get a higher interest rate and huge penalties due to the resulting default.  Debt has destroyed many companies in the current crisis.  Its driven others to the brink and permanently lowered shareholder value in others.  Debt can be very very bad.

But in select cases where the debtload is clearly manageable, frankly, I think companies with a significant debtload and represent unusually good investing opportunities.  For the 2 reasons above:  intrinsic earnings leverage and the ability to improve valuations that the market tags them with as debt is paid down.

3 companies come to mind in this area:

1.  ASH.  ASH got sent from $70 to $5 over debt related to their purchase of Hercules.  Sicne then its recovered about 1/2 way to the mid $30s.  ASH's debt was, in my view, always clearly manageable and I think it'd be silly to think today that it isn't.  They've lumped off debt to the tune of 100's of millions in the few quartesr since the purchase and should continue to do so.  The reduced interest coverage should create intrinsic earnings leverage, and ...  and beefore I had this thought about the intrinsic earnings leverage of debt thats being paid down (due to lower interest costs) I had thought my ASH holdings ... possibly overvalued.  I'm more comfortable holding ASH when viewed from this light.  My ASH holdings are hedged. 

I don't konw if I'd be a buyer of ASH today or not, but I'm very comfortable holding it and frankly I think its overwhelmingly likely that in the fullness of time it moves significantly higher.

2.  BZ. BZ has been ona rocket ride lately, doubling in a few days last week/early this week.  BZ is a similar case.  They have considerable debt at $1B for a market cap thats much lower than $1B.  But they are lumping off debt relatively quickly, and with each chunk of debt thats lumped they increase earnings for the next quarter by reducing interest expenses.  Same basic story as ASH and I think that I'm not a buyer of BZ here, but I will be a buyer on a significant pullback, and in the fullness of time BZ drifts higher than today by an amount worth waiting for.

BZ and ASH are both profitable and both lumping off debt very rapidly.  And...  they demonstrated this well before their shares approached current prices, providing a nice buying opportunity under the thesis of this blog.   Both BZ and ASH have drastically cut costs to attain profitability in a rough environment and that additionally levers their earnings to an improvement in the top line from economic recovery or even just inventory restocking.  

3.  MGM.  MGM has massive, massive debt, many times its market cap.  If MGM can start to lump that debt off, it will free up cash flow from reduced interest coverage, allowing more lumping off of debt, freeing up more...  

and creating a situation where MGMs shares may trade at a multiple of today.  In the fullness of time, it certainly doesn't have to happen soon and the onus is on MGM to demonstrate that they can start lumping off that debt in the coming quarters.  

 

I offer not that one should seek companies with debt.  I simply offer that one should not automatically exclude them, because of the 2 reasons above and those reasons ability to create a situation in which both earnings and the multiple that the stock trades at improve even without growth or an improvement in business.  

ASH was an easy, obvious call in February, BZ was a really good one a couple months ago, and I think I'm a bit ahead of the curve with thinking MGM can get a grip on their debt, start paying it down, and show good earnings in coming years here.

I can always be wrong, and frequently am.  I don't recommend anybody ever take my thoughts on short term market moves as anything but random blatherings, lol

13 Comments – Post Your Own

#1) On August 29, 2009 at 7:19 AM, sentinelbrit (86.26) wrote:

Some of the worst mistakes in managing money can come from not studying the balance sheet. This is particularly true when economic circumstances change for the worse. Of course, it can work the other way round - as we have seen since March 2009. Looking forward, the big question is whether the economy is going to have a double dip recession, in which case, a lot of the stocks that have risen sharply will again come under pressure. It is not surprising that well known fund managers are recommending blue chips now. Such stocks have been left behind in the rally of what purists call, low quality stocks.

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#2) On August 29, 2009 at 9:55 AM, kaskoosek (85.41) wrote:

EV/EBIDA

 

Is a good way to capture undervaluation, eventhough some times earnings are not exactly stable. 

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#3) On August 29, 2009 at 10:43 AM, checklist34 (99.72) wrote:

brit, the whole "blue chips were left behind" or "low quality stocks led the rally" commentaries are ... more or less folly in my view becuase they lack perspective.

GNWis one "low quality" stock thats led the rally, and recently its been mocked widely as part of the "dash for trash".  Yet it trades at well under 1/2 of book and probably about 1/3 of ultimate book, has made some good moves to improve its capital position, and its very very likely that its going to remain a business.  Which means that in the fullness of time it will drift higher than 0.3-0.4 of book.

GNW sustained harm in all of this, it will probably ultimately stabilize at a price well below its previous level.   but its still just over 1/4 of its previous level.  HIG may stabilize at under 1/2 its previous level or whatever, but its still down many times.  At its peak GNW was down 40 times.  So its a 10 bagger from the bottom and a 5 bagger from my average cost...  but its still trading at probably about 1/3 of book and unlikely to cease to be.  

Ditto casino's (although frankly I think the casino stocks in 2006/7 must have had Nasdaq2000 valuations because LVS and WYNN are certainly not cheap today.

 

But aside from that, the mispricing of debt earlier this year is one for the record books.  OSK, ASH, MTW, DOW, TNL all come to mind.  There were more, many, many more.  

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#4) On August 29, 2009 at 10:50 AM, checklist34 (99.72) wrote:

kaskoosek...  I think that calculations based on enterprise value misprice debt negatively and miss alot of value plays at times.

 

again folks, nothing in this thread is espousing picking stocks because they have debt, its observing that debt is mispriced by the market and can provide intrinsic leverage to earnings as its paid down.  

Frankly, I think alot of investors miss alot of great opportunities by ignoring stocks with debt.  ...  my portfolio aside from financials at the march bottoms was mostly ASH, OSK, DOW, RCL, TNL, and casinos.  Basically every holding that wasn't a financial had a debt problem...  I hit triple my money yesterday morning on a broadly diversified set of holdings with basically all the moneyh i've made in my life. 

 

It occurs to me as I type here that debt may be potentially mispriced to the high side during boom times, and mispriced to the low side during recessionary times, creating a significant risk for holding debt-laden companies during big bull markets/boom economies as was pointed out by Brit above.

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#5) On August 29, 2009 at 2:06 PM, portefeuille (99.60) wrote:

It is not surprising that well known fund managers are recommending blue chips now. Such stocks have been left behind in the rally of what purists call, low quality stocks.

A casual glance at the charts makes it pretty clear that this is not a question of "being left behind". U.S. equities have simply gone back to around August/September 2008 levels. Why do people keep looking at charts starting at some arbitrary point in time (all this "year to date" and "since March" garbage). The "full" chart is usually just one click away.

(I do sometimes focus on a certain ("non-maximal") period (for example when I try to "analyse" the current rally), but I also do "the extra click" and am well aware of what "happened" in the other periods.)

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#6) On August 29, 2009 at 2:15 PM, portefeuille (99.60) wrote:

Some have a style
That they work hard to refine
So they walk a crooked line
But she won't understand
Why anyone would have to try
To walk a line when they could fly

 

 

 

 

 

 

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#7) On August 29, 2009 at 3:55 PM, streetflame (30.65) wrote:

Normally I follow Ben Graham's advice and steer clear of companies with high debt.  Particularly so in this environment when we've already seen one of the biggest rallies in history.

But you make some good points.  I'm keeping an eye on a few higher debt companies like TRMD and other shippers, AOI, MFW, HWK, and RJET.

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#8) On August 29, 2009 at 7:22 PM, truthisntstupid (87.13) wrote:

Wow.  You know, I'd have never thought of that!  I won't be tempted to go looking for that kind of situation because I'm a dividend investor and my main objective is building income not capgains but that's really cool.  One of my holdings is WIN.  I wonder if they could enjoy this kind of boost in their multiple and break out to the upside someday.  Of course I probably still wouldn't sell as long as they still had good dividend coverage. Maybe they would use the extra cash to raise it and my yield on cost would be even more than the 11% or so that it is now?

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#9) On August 30, 2009 at 5:57 AM, portefeuille (99.60) wrote:

relative change (in %) of the "outperform" calls I made here (see this post).









 
Almost all of those had "high debt" when I made the call, most of those still do and most where close to a "multi-year low". So as I said before. Catch falling knifes! The average "performance" of those stocks is currently ca. 97.48% and the average "holding period" is about 4 months.

I am also "up" around 200% since March 6 with my "personal holdings". yippieeehhhhhhhh, hehe!

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#10) On August 30, 2009 at 5:57 AM, portefeuille (99.60) wrote:

most where

most were

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#11) On August 31, 2009 at 8:39 AM, sentinelbrit (86.26) wrote:

My point about balance sheets is that in a bull market investors will not worry so much about debt because it provides more leverage in a growth environment. You get higher earnings and a higher multiple. It works in reverse when growth is negative. I have reduced some of my holdings that were troubled by debt - in hindsight, too early. But I still held on for some doubles.

One stock I still like is Radian. It trades at about $8 and has a book value of over $20. I expect more write-offs due to the weak housing market, but there is enough value in the stock that it should be able to ride out the storm.

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#12) On August 31, 2009 at 11:43 PM, checklist34 (99.72) wrote:

porte, 200% has a nice ring to it, especially when asociated with real money... but i like the sound of "triple my money" better.  :))

I am very very pleased to be in this situation, but I'm pained in a way ...  if I'd just followed the advice from my own blog of march 2nd completely, i'd be 4x or so.  that extra 1x would be fun, lol.  

Brit, I think you make a really good point here:  debt should be avoided in  a bull market because if the market turns bearish...  debt becomes a big concern for investors again.  

I'll check out radian.  It sounds familiar, but I've never taken a big look at it...  a really quick look reminds me of GNW.  I completely missed that one at the bottom...

 

 

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#13) On September 01, 2009 at 12:09 AM, checklist34 (99.72) wrote:

streetflame, thanks for the comment.  I absolutely love RJET here.

truthisntstupid, thanks.  I think its an interesting play.  And companies like BZ and ASH that are paying debt down very rapidly even though they are cylicals and the economy is in the toilet seem to have "very manageable debt".  I like this play, MGM is my pick right now for this type of play as BZ and ASH have moved very far from their lows.

The key here, folks, is that the debt is manageable, and most of the time you should probably be looking for situations where the debt is clearly manageable and the shares are completely in the toilet, ... MGM is perhaps a bit of a spec play here, but with City Center coming...  and the enormous capex of recent  years fading, I think they will start lumping down debt in a quarter or 2 and beginning the process...

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