Do not invest in companies merely because they have lots of cash. Instead select those that use the cash better
An economic a slowdown leads to falling demand. Rising interest cost to service the debt taken earlier either for capacity expansion or inorganic growth is the last thing that a company and an investor would want. So while many debt-heavy companies see their profitability erode during a downturn due to the high interest cost component on loans taken to fund capital-intensive grassroots projects or to finance acquisitions, companies with little or no debt have no such worry.
Low debt (or leverage) not only keeps a company's interest cost down, but also gives it flexibility to invest its cash back into the business to expand or develop new products. As debt-free companies are mostly cash-rich, they also do not need to raise large funds from the market to run their operations.
There are many other advantages that debt-free companies enjoy. For instance, debt-free company need not keep aside a portion of the profit to meet the cost of capital. They get interest on their cash deposited with banks, adding to their reserves. They have low interest-rate risk.
However, debtless companies have their share of disadvantages, too. It shows that the company is not proactive on expansion and, thus, would be left out on growth rates when the environment turns bullish. There would be lower chances of debt-free companies getting long-term debt at short notice during an emergency as the company will not have a sufficient debt history to boast.
A zero- or low-debt company, therefore, is not always worthy of investment. Investors have to look at many other factors. "Apart from debt, investors should look into the earning per share, financial history, prospects of the company in the coming years, the sector in which it is operating and last, but not the least, the price earning multiple of the share," says Alex Mathew Head of Research, Geojit Financial Services.
For instance, large IT companies like Infosys Technologies and TCS may not have interest-rate concerns. But their prospects would always be subject to other important factors including exchange rate fluctuations and economic conditions in the US and other major export markets. Not surprisingly, despite being zero-debt companies, IT companies are out of favour of the market at present.
Similarly, it is not always unwise to invest in companies with large amount of debt. Proper use of debt to build new capacities, purchase inventories and make strategic acquisitions in favourable market conditions bring better returns on equity. In most capital-intentive industries, not taking debt is not practical. Equity investors will not like to fund big projects entirely as this will bloat equity capital and reduce return. "Debt is a very small component in the valuation of a company," says Avinash Gupta, Assistant Vice President, Research-Equity, Bonanza Portfolio. "Valuation is largely based on the free cash generated over a period of time, which is the resultant of business potential and capital structure,"
Debt-laden companies can enjoy the benefits of expansion and have better chances of getting more debt as they have a debt history to show. Heavy debt companies, whose operational risk is not high, (i.e., continuity of revenue and profitability is visible) get higher return on equity capital invested.
Debt is good as long as the combined financial and operational risks tend to give right return. "It is wrong to paint debt-free and debt-laden companies with the same brush without looking at the specific business of the company," says Pankaj Chopra, CEO, Iden Investment Advisors. "In the current environment, it may appear that low debt is a good thing. But if the company maintains low debt even when interest rates are low and there is strong business visibility, then its competitive advantage would be lower than others who use low-cost debt more fruitfully."
Debt-laden companies, however, have the disadvantages of keeping some portion of the profit for payment of cost of capital. "The key is to have optimum debt-equity ratio to enhance return to equity shareholders and at the same time reduce balance sheet risk," says Manish Sonthalia, Senior Vice President, Research and Strategy, Motilal Oswal Financial Services. "Hence, it is not true that debt-free companies are always good for investment or debt-laden companies are bad investment choices."
Capital Market decided to study the stock performance of debt-free companies in relation to the BSE Sensex. A list of companies with zero debt was compiled. A further filter was applied to restrict the list to companies with a minimum market cap of Rs 1000 crore.
The list of debt-free companies were dominated by MNC associates, IT companies and PSU companies. They accounted for 71% of the sample. While 12 MNC companies featured in the list, there were seven PSUs and eight IT companies of the total 38 companies that met the criteria of zero debt/equity ratio companies with a minimum of Rs 1000-crore market cap.
Zero-debt MNC companies in the list included ABB, Siemens, GlaxoSmithkline Consumer Healthcare, Crisil, ICI (India), Gillette India, P&G Hygiene, Aventis Pharma, Pfizer, GlaxoSmithkline Pharma, Astrazeneca Pharma and 3M India.
Debt-free IT companies (including MNCs) comprised Infosys Technologies, TCS, Satyam Computer, Oracle Financial, MphasiS, Patni Computer, Info Edge (India) and Sterling Intl.
There were also quite a few debtless PSU companies. They were NMDC, National Aluminium, Container Corporation, Bharat Electron, MTNL, Engineers India and PTC India.
But not all debt-free companies in the list fared well on return. Some lost more, some lost less. But, on an average, debtless companies with Rs 1000 crore and more market cap performed exactly in line with the BSE Sensex, losing on an average 57% of the market cap as against 56% lost by the BSE Sensex between 1 January 2008 and 27 November 2008.
MNC and IT companies outperformed the market fall. The 13 MNC companies lost 55% of their market cap on an average. Market capitalisation of IT stocks shrank by 39% on an average. However, eight debt-free PSUs lost 68% of their value on an average.
Debt-free pharmaceutical companies (which were all MNCs) with a market cap of Rs 1000 crore and more lost 10% on an average. On the other hand, debt-free FMCG companies (which were incidentally all MNCs) shed 32%.
In comparison with the BSE's sectoral indices, the BSE FMCG sector lost just 21%, the Healthcare index 36%, and the BSE IT index 45%. On the other hand, the BSE PSU index shed 57%.
While debt-free MNC pharmaceutical and IT stocks with market cap of more than Rs 1000 crore outperformed both their sectoral indices and the BSE Sensex, debt-free PSU stocks with market cap of more than Rs 1000 crore underperformed both the BSE Sensex and BSE PSU index. MNC FMCG companies also underperformed. But that was due to the unprecedented rise in commodity prices, which have fallen massively of late.
The fact that debt-free PSUs with a market cap more than Rs 1000 crore lost on an average 68% compared with the 56% market-cap loss of the BSE Sensex means investors are not comfortable with PSUs in spite of being debt-free. "This implies that PSU managements do not have the drive/incentive to generate high return on equity (ROE)," says Pankaj Chopra, CEO, Iden Investment Advisors. "Remember, debt means risk and the managers of these companies just do not want to take on risk. There is no incentive for them to do so."
There is no rationale, however, for utility companies not to return shareholders' money and take on some debt. The key is management vision. The problem is lack of continuity of management in PSUs. So even if there are some who give it a vision, they tend to be replaced in a couple of years. So the vision is lost.
IT and MNC FMCG companies have low debt because of low requirement of capital, and high profit margin. They are also mostly in secular businesses, where growth is sustained out of the retained earning. Increased profitability and low capital lead to higher ROE/ return on capital employed (ROCE), resulting in higher P/E.
MNCs in India are funded by their parent companies. The MNC parent is likely to have taken debt to offer higher return to its own shareholders. Hence, there is no intention to leverage the Indian associate/subsidiary.
Non-pharmaceutical and non-FMCG MNCs (excluding MNC IT companies) such as ABB, Siemens, Crisil, ICI (India) and 3M India as a group lost a massive 68%. Individually, ABB lost 71% of its market capitalisation, Siemens 71%, while 3M India, Crisil and ICI (India) 57%, 34% and 30%, respectively. In comparison, the 38 debt-free companies with a minimum market cap of Rs 1000 crore cap lost 57% on an average.
Once market darlings ABB and Siemens have fallen much more than the market due to their relatively high valuation. Even their debt-free status could not help them. These companies cater to industrial demand. There are doubts whether their business growth will be as robust as the market was earlier expecting it to be. The market likes visibility in earning and stock prices are nothing but a reflection of future earning potential of a company. Stock prices start discounting two-three years of earning in advance. This is the reason that Siemens and ABB were quoting at very high P/Es earlier. When the visibility in earning reduces, as is happening now to both these companies (margin compression, low fresh order intake, low revenue growth), prices correct to reflect that change. This is regardless of the fact whether the company has high debt or no debt and has more to do with the changing business dynamics.
Though debt-free companies, on an average, have been market performers, the market seems to have taken the zero- or low-debt status positively when compared with highly leveraged companies. The market cap of the top 50 highly leveraged companies, i.e., the ones with high debt-equity ratio, fell 75% on an average, the market cap of the top 100 highly leveraged companies dropped 83%. The market cap of 322 companies with debt-equity ratio of 2 or more declined 76% on an average.
In the current scenario of high interest rates and slowdown in economy, debt-free companies offer a good avenue for investment. However, fund managers do not make investment decisions solely on the debt status of a company. Investment can be avoided in debt-free companies where growth conditions remain weak and despite net cash/low debt would not lead to any worthwhile appreciation in the stock price.
On the other hand, debt-laden high growth companies, with quality management and where prospects of earning are positive, should be assessed for investment.
Investment in these companies ought to be evaluated regularly as, in a period of downturn, these companies may incur lower earning/losses due to higher interest outgo. In certain cases, the company may also find the going difficult. This is reflected in lower share prices of these companies.
Debt-free stocks that have outperformed the current bear phase are likely to be underperformers when the uptrend resumes. Majority of debt-free companies fall under the tags of Old Economy and defensive sectors. These stocks have lower betas (volatility), which are very close to 0.75 as against a bet of 1 taken for the broad market. In a falling market, the rate of fall will be substantially lower compared with other stocks. But in a bullish market, these stocks will rise only marginally.
Whether a debt-free or debt-laden company is a good investment bet depends on case-to-case basis. Investors need to see if the business environment of the company is good and warrants the debt it has taken, and if it will be able to refinance that debt. It is very much possible that a company that has debt is more attractive than another which does not have debt. But as the economy is slowing down, debt-free companies — MNC FMCG companies in particular —are good bets to keep volatility of the portfolio at bay.
