Why Good Performing Shares can come with Debt

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Last week, I wrote an article and shared a great screen which might help find good dividend shares. But, it may also have implied that an investor should only look for companies which do not come with any debt.

While having no debt or less debt is generally a desirable trait, the reality can be a little more nuanced. The reason is that for some types of businesses, debt is part of a daily corporate staple.

And in fact, not having any debt in a company alone is not an iron-clad guarantee that its shares would subsequently perform.

Let’s do some comparisons

Take StarHub Ltd. (SGX:CC3), for instance, a well-known mobile and cable service provider in Singapore. I have summarized the company’s cash and debt levels in the graph below. Over the last five financial years, the company has been consistently holding more debt than cash. In fact, in 2013, Starhub had recorded a net debt position of $421 million.

Source: Morningstar

In contrast, let’s look at Venture Corporation Ltd (SGX: V03). The company’s primarily a contract manufacturer and provider of technology services, products, and solutions. It has been able to remain in a positive net cash position for the same duration as shown below.

Source: Morningstar

On the surface, it would seem like Venture Corporation would be a shoo-in for the better performing share among the duo over the last four years given its much stronger balance sheet. However, when we compare the share price performance of the two companies from 2 January 2010 to 25 August 2014, the conclusions turn out to be quite different.

Source: Google finance; Starhub (red), Venture (blue)

On a capital gains basis, Starhub has been able to dial-in a 91% return during this time period. Meanwhile, Venture Corporation’s share price actually fell by a little under 9%. For some context, the SPDR STI ETF (SGX: ES3), a proxy for Singapore’s share market benchmark the Straits Times Index (SGX:^STI), returned a little over 13% in the same period.

The business behind the ticker matters

So, what caused the divergence in returns between Starhub and Venture Corporation despite the latter possessing the superior balance sheet?

One clue to this is that Starhub has fewer competitors in its space compared to the global competition that Venture Corporation faces.

Based on Starhub’s 2013 Annual Report, the company boasts 2.351 million mobile subscribers and 448,000 residential broadband connections in Singapore. The scale of its service operations as well as cable connections which run into the homes of many Singaporeans gives it a sizable economic moat in terms of barriers to entry into its industry. This is best reflected by its low churn rate of about 1%  (what this means is that annually, only about 1% of customers leave Starhub for another provider) in the past financial year.

The low churn rate gives Starhub stable cash-flows which in turn allowed it to generate $292 million in free cash flow in 2013. Assuming Starhub’s annual free cash flow stays constant and it uses all of the free cash flow to repay its borrowings, it would take less than three years for the company to get rid of all debts.

Foolish bottom line

As much as investing guidelines, screens and numbers matter, you should always keep in mind that the nature of a business may well be an overriding factor in your evaluation of a company.

Perhaps Warren Buffett summarizes it best when he once quipped that “Investment is most intelligent when it is most businesslike”. As a lifelong student of Foolish investing, it may be wise to consider letting a business lead the way forward and use financial numbers just to keep score. It pays to be aware of what we give up when we start using a financial metric alone to drive our investing decisions. The numbers after all, don’t tell the whole story.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.