Stocks with relatively stable fundamentals such as lower debt on the books, steady growth rate, quality management, and unique product portfolio are considered ‘safe’ option for investors to park their money for a slightly longer period of time.
Stocks with low debt compared to Industry average or no debt is one such measure to filter out stocks which are considered safe options or less volatile. Debt-to-equity (D/E) ratio is used to measure company’s financial leverage and is calculated by dividing total liabilities by stockholder’s equity.
“Companies carrying lower debt on their books are relatively safe for investors as they may not face stress from debt servicing in bad times. There is a set of investors who actively look out for companies who either have low debt on their books or are actively bringing down their debt,” Deepak Jasani, Head - Retail Research, HDFC Securities told Moneycontrol.com.
A brief analysis showed on stocks in the S&P 500 companies showed that many companies who have either zero debt or debt component which is less than industry’s average gave more than 50 percent returns on an average.
Having zero debt or minimal debt is one of the key drivers of stock price outperformance, but not the only factor. Hence, investors should look at various other parameters before putting their money.
“Investors prefer minimal debt companies given the fact that during the period 2007-17 many midcap companies took on huge debt to fund aggressive expansion plans and are still struggling to reduce gearing,” Jaspreet Singh Arora, Head of research- Institutional Equity, Systematix shares told Moneycontrol.com.
“Any company having zero or minimal debt (mostly working capital) is regarded highly by investors today. Most of the companies in the table qualify for a Buy. However one needs to consider other parameters also like valuations, earnings growth, management pedigree, etc.,” said Arora.
If we look at the stocks which gave multibagger returns, most of then rallied on hopes of strong earnings recovery, stability in demand environment, as well as growth prospects.
“Both low D/E companies and high D/E companies have done well in the last one year. Low D/E companies would have their own micro reasons for performing well (eg defensive nature, hive-off/demerger/restructuring, beneficial stage of cycle, improving order visibility etc.),” said Jasani.
“In a falling interest scenario, companies with high debt will get more than proportionately benefited. Hence, the stage of the cycle of the industry, the efficiency of capital allocation, the management quality, the robustness of cashflows etc. are some other parameters that also need to be considered in addition to theD/E ratio,” he said.
What is ideal D/E ratio?
The ideal D/E ratio defers from industry to industry. For example, infra/reality (1-3x), construction/cap goods (1-2x), manufacturing like cement, auto (0.5-1.5x) while consumer/IT have surplus cash.
“While debt gives a push to sales growth it also comes at risk of muted earnings growth if leverage is high or interest rates trajectory is upwards. Investors prefer companies who can fund their working capital and capex requirements from internal cash generation,” said Arora of Systematix shares.
“For companies who have negative FCF, and therefore require funds, debt is always preferred over equity as long as it comes at cheaper cost of 9-12% vs equity,” added Arora.
Zero debt is a function of free cashflow generation and capital intensity of the business. Zero debt is a trait of a well-managed company.
If the company is generating free cash on a consistent basis sufficiently and managing growth through its internal accruals, it’s a good business to invest in, suggest experts.
Generally, D/E ratio lesser than 1 is preferred from an equity standpoint. However Debt to EBITDA and Interest coverage ratios decide the level the company can comfortably take.
“An apt capital structure should have a mix of debt and equity. Building scale through debt, helps to reduce the overall cost of capital for the company and fetches a better return on investment (ROI),” Shashank Khade, Director and Chief Equity Advisor at Entrust Family Office Investment Advisors.
“An ideal D/E ratio is a function of the company’ cashflows, operating profitability and what the company can service. Debt/equity level cannot be universally be applied for all types of companies,” he said.