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One Easy Way To Pick Your Investments

‘Please stay out of debt’ is perhaps one of the most important financial lessons individuals can get. After all, being mired in debt means that whatever income you earn from all your back-breaking or mind-twisting toil goes toward paying-off holders of your IOUs rather than building a better future for yourself.

But, is this advice true for companies as well? Is ‘stay out of debt’ useful advice for companies in general?

Turns out, it might well be.

Financial blogger Dan Myers did a fascinating study on 490 of the largest American stocks by market capitalisation. He ranked these stocks by their Debt-Ratios and compared a wide range of operational metrics and return-figures for them for 10 years from 2003 to 2013. (More details on the debt ratio and the findings of his study can be found at the bottom of this article.)

He found that, in general, debt-ridden companies are significantly out-performed by companies which operate with less leverage.

The late Walter Schloss, a value investor with a phenomenal track record, was once quoted as saying: “I like to look at the balance sheet and I don’t like debt because it can really get a company into trouble. I prefer to buy basic businesses with strong balance sheets.”

The study also showed that debt does not have any beneficial impacts on corporate results. Instead, debt has the potential to cause lots of problems for companies – a company can go insolvent or bankrupt with debt.

Of course, there will be exceptions to the rule, but the data does show how the odds of better corporate performance are skewed toward companies with low or no debt.

In fact, it is my opinion (and one shared by Myers) that companies with no or low debt might be a ‘symptom’ of them being engaged in businesses with strong economic moats, i.e. businesses with the ability to generate above average profit margins and cash flows over sustained periods of time.

There’s no need for much use of ‘other people’s money’ if a business can generate most of its cash needs internally through a strong economic moat (and that is likely to be a good sign for investors).

Within the Straits Times Index (SGX: ^STI), there’s also a range of leverage that’s been used among the index’s 30 constituents.

Some of these blue chip’s debt ratios (as defined by Myers) are shown below:

Company Debt Ratio (as of 14 December 2014)
Thai Beverage Public Company Limited  (SGX: Y92) 0.33
CapitaLand Limited  (SGX: C31) 0.37
Starhub Ltd  (SGX: CC3) 0.36
Singapore Exchange Limited  (SGX: S68) 0.00
SIA Engineering Company Limited  (SGX: S59) 0.02

Source: S&P Capital IQ

Does this mean that SIA Engineering and SGX might have significantly better moats than say, Starhub and Thai Beverage?

There’s certainly such a possibility, though that would entail a deeper dive into their businesses.

At the very least though, Myers’ work gives us a useful tool to add to our toolkit in sieving out attractive investing opportunities.

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Details of Myers’ study

The Debt-Ratio, as used by Myers is as such:

Debt Ratio = (Short Term Debt + Long Term Debt) / Total Assets

Myers then split these companies into six categories as shown in the table below:

Debt Ratio Category
0 No Debt
0 to 0.2 Low
0.2 to 0.4 Mid-Low
0.4 to 0.6 Mid
0.6 to 0.8 Mid-High
0.8 High

 

The results of his study is shown in this chart:

Debt

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