Factoring in the risk of excessive corporate debt

This is the fourth in a short series of blog posts covering my stock screen and investment strategy updates for 2019 and beyond.

Here’s a list of all the posts in this series:

1. Why I’ll be looking at reported earnings instead of adjusted earnings from now on
2. Why I’m measuring capital employed growth instead of earnings growth
3. Companies with thin profit margins often make bad investments
4. This post
5. Investing in turnarounds, recovery stocks and corporate transformations

Note: This post covers an update to my Debt Ratio metric. If you’re not familiar with it then here’s a link to the original blog post from 2014. And here’s a link to the related and updated Company Analysis Spreadsheet (XLS).

For the last few years I’ve used a debt ratio which compares a company’s total borrowings to its recent average earnings (i.e. post-tax profit):

Debt Ratio = Total borrowings / 5yr average adjusted earnings

In terms of highlighting companies with excessive debts, I think this ratio has worked reasonably well.

However, I have decided to make a few minor adjustments for 2019:

1) Use reported earnings instead of adjusted

Along with all my other ratios that use earnings, I’m switching the Debt Ratio from adjusted to reported earnings.

2) Use ten-year average earnings rather than five-year

The Debt Ratio will now use ten-year average earnings rather than the five-year average. So the ratio is now:

Debt Ratio = Total borrowings / 10yr average earnings

There are two reason for this change:

a) Reduce sensitivity to unusually good or bad periods

I want to invest in companies with debts that can easily be supported through their next business cycle, and one problem with five-year average earnings is that five years is shorter than most business cycles.

What if the last five years were unusually good and what if the next five years are dominated by an industry slump?

In that case a prudent Debt Ratio based on five-year earnings may in fact not be so prudent after all.

Switching to ten-year average earnings should help to reduce the impact of unusually good or bad periods on the Debt Ratio.

b) Require less debt for high growth companies

While high growth companies can make good investments, their high growth rates can bring additional risks.

With high growth comes large numbers of new employees, new layers of management, new processes, new equipment and machinery, new suppliers and new customers.

And as with anything new, there may be problems to be ironed out, grooves to be greased and relationships to be built.

This is normal, but it does bring risk and greater operational risk should – in my opinion as a shareholder – be offset with a stronger balance sheet.

Using ten-year average earnings will automatically make the Debt Ratio more demanding for high growth companies.

That’s because their ten-year average earnings will be significantly lower than their five-year average earnings, and lower average earnings combined with the same amount of debt will mean a higher Debt Ratio.

Since my Debt Ratio limits remain the same (a ratio of four for defensive sector companies and five for cyclical sector companies), fast growing companies will need to have less debt than before for their debts to be considered prudent (i.e. below those Debt Ratio limits).

2) Include the Debt Ratio as a ranking factor in the stock screen

Previously, the Debt Ratio wasn’t used to rank stocks on my stock screen.

Instead, each stock’s rank was calculated from its Growth Rate, Growth Quality, Profitability, PE10 and PD10, and the Debt Ratio was used as an additional but non-ranking consideration.

The problem with that approach is that if one of the stocks in my model portfolio sees its Debt Ratio increase to the point where it breaks one of my debt-related rules, that wasn’t reflected in the stock’s rank.

Since I want the stock screen to highlight stocks with the best combination of growth, income, quality, value and risk, it doesn’t make sense to leave the debt ratio out of the ranking process.

So from now on, it won’t be.

The upshot of this is that the screen will now favour companies with below average levels of debt, and if a company’s debts rise, then (all else being equal) its position on the stock screen will fall.

The dangers of highly capital intensive companies

The next post in this series was going to cover capital intensity; primarily the ratio between capex and profits.

However, since I’ve increased my minimum acceptable return on capital employed from 7% to 10% (which I mentioned here), the issue of excessive capital intensity has faded away.

In other words, very few highly capital intensive companies (think phone or energy utilities) generate attractive rates of return on capital employed, and very few companies generating attractive rates of return on capital employed are highly capital intensive.

Turnarounds and transformations

So instead of capital intensity, the next and last post in this ‘2019 updates’ series will cover what I’ve learned from investing in turnarounds and transformations.