Eric Schoenstein, co-manager of the Jensen Quality Growth Fund, likes investing in high-quality companies that don’t need to borrow money to grow. Problem is, with interest rates virtually nil and even the junkiest of companies able to load up on cheap debt, the ability to self-finance growth doesn't count for as much as it used to. That’s one reason Schoenstein’s fund has lagged peers and the S&P 500 in the last three years.
That contrasts starkly with the fund's 15-year annualized return of 6.5 percent, which tops the S&P 500's 4.3 percent as well as the returns of 92 percent of its large-cap growth fund peers, according to Morningstar. And Jensen's fund won’t lag for long if history is any guide.
According to a 2010 study of 413 non-financial stocks in the S&P 500 by France's SKEMA Business School, buying the 10 percent of stocks with the lowest debt levels and holding them for three years would lead to a cumulative 17 percent outperformance of every other stock in the group. (Financial stocks were left out because they record debt differently on their balance sheets.)
The strategy worked fairly consistently from 1985 through 2004 even when adjusted for extenuating factors such as sector concentration, market cap, volatility and valuation.
The results go against the basic principles of modern portfolio theory (MPT). The founding fathers of MPT, Franco Modigliani and Merton Miller, believed that debt and equity were the same as far as their impact on corporate performance went. In their imaginary efficient market, adding more debt didn't increase risk any more than adding equity. Debt just efficiently amplified returns. So a company with $100 million in equity that added $100 million in debt to its balance sheet would see twice the upside in a bull market.
Despite a strongly rising market during the study’s period, the opposite proved the case. “It’s time for a paradigm change,” says Gulnur Moradoglu, author of the study and a professor of finance at the University of London. Although Moradoglu didn’t update her study in the U.S. to include the 2008-2009 credit crisis, she did for European stocks and came up with similar results. Given the nature of the crisis, that should come as no surprise.
To Schoenstein what the academics have long missed is self-evident. “There’s no question that having the ability to be more self-funding and not as reliant on debt capital simply gives companies far more operating flexibility,” he says.
Some of the best value managers also see the advantages of a strong balance sheet. One of the key tenets of the Graham & Dodd school of value investing is to create a “margin of safety” by buying a stock selling below its book value. But safety can only be assured if the balance sheet will not implode.
That's why investors like Warren Buffett define risk as the likelihood of "the permanent impairment of capital” -- that is, the likelihood of a company going bankrupt. That perspective is in sharp contrast to MPT academics who define risk as stock price volatility. Value managers often see volatility as an opportunity to buy good businesses on the cheap.
That doesn’t mean modern portfolio theory should be thrown out the window. While companies with the lowest debt levels outperformed by the largest margin in Moradoglu’s study, those with the highest debt levels outperformed as well -- by 8.4 percent.
Quantitative money manager Harin de Silva of Analytic Investors says the stock returns on leveraged companies are “J-shaped.” In other words, low-debt companies do well while more leveraged companies do worse and then the returns improve again at the highest debt levels. “If you have a lot of debt, you actually get a premium return because your chance of bankruptcy is high,” says de Silva. That makes sense according to modern portfolio theory -- more risk equals more reward.
Short vs. Long
Even here there are wrinkles. According to a working paper by Engin Kose of quantitative fund shop Research Affiliates in Pasadena, it’s not stocks of companies with high debt loads in general that do well. It's companies with high short-term debt maturing in less than a one year.
“Short-term leverage is feared by the market, long-term leverage is not,” say Rob Arnott, Research Affiliates’ chief executive officer. “So short-term leverage predicts better returns, not worse, because those companies are so deeply out of favor.” Investors worry companies won't be able to renew or “roll over” short-term debt when it matures, and overreact. Long-term debt is as risky but investors shrug it off. So stocks with a lot of long-term debt are often overpriced.
Right now, there's no easy way for individual investors to play these debt anomalies. “At some point I think the exchange-traded fund (ETF) market will evolve to where there are high debt and low debt ETFs,” says de Silva.
IShares does have an ETF, the IShares MSCI USA Quality Factor ETF, in registration with the Securities and Exchange Commission. MSCI's Quality Indices, launched last December, screen for companies with low leverage, as well high return on equity and low earnings variability.
More products will likely show up in the near future -- it’s only a matter of time before interest rates rise and the easy money policies of the Federal Reserve tighten again. When debt becomes difficult to come by, the low-leverage/high quality strategy will shine.
Maybe investors looking ahead to higher rates have already started to take notice. For the year to date, the Jensen Quality Growth Fund is up 12.6 percent, besting the average large-cap growth fund by 2.4 percentage points.
(Lewis Braham is a freelance writer based in Pittsburgh.)
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