Five Stocks Killing the S&P 500: the Joys, and Profits, of Investing in Debt-Free Companies
If you want to feel a lot better, eliminate your debts. I was debt-free once, briefly, in my late 30s. I practically floated to my office. I slept like a rock, had large thoughts, exuded confidence and laughed longer.
If you can’t eliminate your own debts, reduce your off-balance-sheet leverage: Trade stocks in high-debt companies for those that are almost debt-free. There aren’t very many in the S&P 500. I only count 29 of them with liabilities that are less than 10 percent of their oversimplified enterprise values.
Wha-huh? What’s oversimplified enterprise value? I’d better explain.
YCharts recently added a new solvency ratio to its stock screener that I’m excited about. It is called “liabilities / market cap plus net liabilities.” The denominator—stock market capitalization plus total liabilities minus cash and equivalents—is what simpletons like me like to call enterprise value but some smart people say really isn’t.
Quite reasonably, financial wizards like to subtract all kinds of things from enterprise value, like receivables that are offset by payables. But sometimes I think financial analysts are too smart for their own good. If counting all of a company’s liabilities on the way to computing its enterprise value is oversimplifying, so be it.
When I am measuring the true indebtedness of an enterprise, I like looking at liabilities as a percentage of oversimplified enterprise value even more than I like looking at debt to equity ratios. The latter ignores short-term debts—a reasonable thing to do when debt is readily available, but what about when lenders stop lending, as they did in 2008?
Anyway, back to debt-free stocks. As I said, there are 29 stocks in the S&P 500 with liabilities that are less than 10% of their oversimplified enterprise values. And investors adore these low-debt stocks. The typical S&P 500 stock is trading at around 16 times earnings. These 29 stocks trade at an average PE ratio that is twice as high.
The fact is, low-debt companies should trade at higher multiples. Less of their operating income is siphoned off to service debt. More of it is available to be reinvested into their business, used to repurchase shares or even distributed as dividends to shareholders.
Just six of these low-debt outfits that have PE ratios below 20, in fact, but they include some juicy names. Apple is the biggest. It’s a fantastic stock—remarkably cheap considering the quality of its management, the hold it has on consumers and its solid prospects. We write a lot about Apple (AAPL) at YCharts, though, so I won’t repeat what others have said now. Instead, let’s focus on the other five companies.
They are luxury leather-goods purveyor Coach (COH), based in New York; aerospace-parts manufacturer Precision Castparts (PCP), of Portland, Ore.; telecommunications products maker Qualcomm (QCOM), based in San Diego, discount variety store chain Dollar Tree (DLTR), based in Chesapeake, Va.; and Fossil (FOSL), the maker of fashionable watches and jewelry.
All five stocks have trounced the S&P 500 in the past year, as seen in a stock chart.
And as I’ve said they’re all very lightly leveraged. I can’t show you a chart of their liabilities as a percentage of oversimplified enterprise value, but take a look at their debt to equity ratios.
What you find out if you study low-debt companies for a while is that their distaste for fixed cash payments will often apply to their dividends. Only three of these companies distribute any cash dividend, and just a small one at that—let’s face it, these stocks are not yield plays.
What these managements really love is growth. Each company’s trailing-twelve-month revenues per share has been rising. Even Precision Castparts, the slowest grower in the group, has boosted its revenue per share significantly faster than inflation since 2008. (The chart below shows percentage changes.)
The earnings per share of all five companies have also risen steadily. The chart below shows percentage change in trailing-twelve-month EPS for each firm since 2008.
When a debt-free company’s revenues per share go up, its earnings per share don’t rise as quickly as that of a company with leverage. (And investors who leap past a low-debt firm’s shares to purchase those of its highly indebted rival may be making a mistake—the latter’s earnings will also tumble more quickly if demand for both firms’ products cools.)
But what’s nice about low-debt companies is that because they are spending less money servicing debt, they have lots left to repurchase shares.
So in an era when lots of companies are diluting shareholders by making new shares available on the market, three of the five companies have been reducing the number of shares they have out, giving existing shareholders a nice boost.
In the coming days, I’ll pick one or two of these five companies to study and write about in greater detail. Feel free to jump into the comments section of this story and tell me which one you think is the best value of the five and which is the worst.
Stephane Fitch is a contributing editor at YCharts, which includes the just-released YCharts Pro Platinum for professional investors.