By Justin J. Carbonneau (@jjcarbonneau) —
“I do not like debt and do not like to invest in companies that have too much debt, particularly long-term debt. With long-term debt, increases in interest rates can drastically affect company profits and make future cash flows less predictable.”
— Warren Buffett
Of the twelve quantitative models we run publicly on Validea, nine of them look at a company’s level of debt in their assessment of a firm’s financial strength. In all cases, lower debt is favored over high levels. This makes sense as high levels of debt impact the interest a company pays, which impacts profitability. High levels of debt also mean there is less is less equity for shareholders, higher risk of bankruptcy, potentially less of an ability to borrow in the future, and higher borrowing costs if interest rates increase or debt covenants are breached. So one would think it’s a slam dunk that high debt is bad. But not so fast.
In 2015, Dan Rasmussen and Brian Chingono of Verdad Fund Advisers published a research paper titled “Leveraged Small Value Equities“. What the authors set out to prove was that a low cost, systematic approach, which sits at the core of passive investing, could be combined with the leveraged buyout approach of buying companies at a discount that are highly leveraged and that use cash flow being generated by the business to pay down the debt over time.
The approach outlined by Rasmussen and Chingono, which takes it roots from the private equity world, takes the whole idea that more debt is bad and turns it upside down. Their point is leverage can actually be a big positive for returns in the publicly traded small cap space if you buy cheaply and if the firm has the ability to use cash being generated by the business to pay down debt.
“Once you get the deleveraging flywheel going, you can see very impressive equity returns,” said Rasmussen referring to his small cap leveraged value strategy in a 2016 Forbes article. As the piece pointed out, as debt comes down, it increases owners’ equity and helps lower the risk of bankruptcy, and so you get multiple expansion. This is very different than most value investors’ take, and very different from the guru models run here at Validea. But as anyone investing in the market knows, there are infinite ways to aim for market outperformance and often times it’s the non-consensus view or approach that is needed.
Rasmussen recently was on the Meb Faber podcast. This is a nice long form interview (link here) that provides good insight into his line of thinking when he developed the approach and model’s inputs.
In the paper, the authors tested their small cap levered quantitative strategy from 1965-2013 and the top 25 value-weighted portfolio, which would have held the top 25 ranked names based on the combined factor score, had a hypothetical return of 25.1% annually. To put this in perspective, the S&P with dividends would have returned about 10% over that time period and Warren Buffett, who took control of Berkshire Hathaway in 1965 would have been up about 21.6%. The returns would have been well above the returns achieved in private equity as well according to the authors.
As the research paper and podcast to some extent point to, there are two cuts to the underlying strategy that go into identifying the top ranked stocks. The first is to define the universe (i.e. small cap and value) and the second step is to apply a set of additional analyses on top of the universe in order to identify the stocks with the most potential.
In defining the universe, the model looks for stocks in-between the 25th and 75th percentile in terms of market capitalization in the small cap segment of the market. It then further reduces the list by identifying the cheapest 25% based on Enterprise Value (EV) / EBITDA. The final criteria in terms of segmenting the universe is looking for those stocks with an above-median leverage ratio relative to all stocks in the market. This is the “leveraged small-value stock” universe where the opportunities can be found.
To uncover those stocks with even more excess return potential, a second set of factors across four different areas are applied: deleveraging factors, technical factors and quality factors.
As the authors state in their paper, “The ideal leveraged stock has high Gross Profit/Assets, and low-to-moderate LT Debt/Assets, a low valuation in terms of EV/EBITDA, and a high level of LT Debt/EV.”
One of the things you’ll notice in the table above is that the Top 25 Portfolio demonstrated a significant amount of volatility, with a standard deviation of 40%. For most investors that type of volatility, particularly to the downside, would be very hard to deal with, but the Sharpe ratio of 0.51 shows the strategy more than compensated for the risk with the excess returns that were generated.
The Forbes article mentions the returns of the model over the past few years have not been as high as the back-test in the research paper. This is consistent with Validea’s implementation of the model as well. Of the 42 quantitative strategies we track, the performance from 2006-2017 puts the portfolio we’ve tested and run just above the middle of the back in terms of its long term results. However, it’s important to note that small caps and value stocks have struggled to keep pace with other areas of the market over the last 5-7 years, and when small cap value comes back into favor this is one strategy to keep an eye on.
The list of stocks below are a sampling of some of the names that pass the leveraged small-value stock strategy we’ve captured quantitatively. These are not buy recommendations, and in isolation any of these stocks are highly risky, but the list should give you a sense of where some of the value is in the small cap space using the method outlined in the research paper.
So next time you hear that companies with high debt are all bad, remember, that may not always be true, particularly when you know what you are looking for in the small cap value part of the market.
|MCS||MARCUS CORP||$717||Services||Motion Pictures||18.59||0.8157|
|LCI||LANNETT COMPANY, INC.||$777||Healthcare||Biotechnology & Drugs||18.41||1.4432|
|SSW||SEASPAN CORPORATION||$874||Transportation||Water Transportation||15.43||1.5665|
|ECPG||ENCORE CAPITAL GROUP, INC.||$1,056||Financial||Regional Banks||11.64||5.5112|
|GTN||GRAY TELEVISION, INC.||$1,414||Services||Broadcasting & Cable TV||8.73||3.1102|
|LPNT||LIFEPOINT HEALTH INC||$1,916||Healthcare||Healthcare Facilities||11.51||1.2629|
|ARCH||ARCH COAL INC||$1,920||Energy||Coal||1.7||0.4648|
|VHI||VALHI, INC.||$1,971||Basic Materials||Chemical Manufacturing||25.98||3.8425|
|VNTR||VENATOR MATERIALS PLC||$2,234||Basic Materials||Chemical Manufacturing||38.23||0.7433|
|CXW||CORECIVIC INC||$ 2,637||Services||Business Services||13.35||0.9675|
|NOMD||NOMAD FOODS LTD||$2,935||Consumer/Non-Cyclical||Food Processing||22.6||0.7718|
|RLGY||REALOGY HOLDINGS CORP||$3,581||Services||Real Estate Operations||15.93||1.3141|
Photo: Copyright: wisitporn / 123RF Stock Photo
Justin J. Carbonneau is Partner at Validea Capital Management and Validea.com. You can follow Justin on Twitter @jjcarbonneau.