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.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

3 thoughts on “Factoring in the risk of excessive corporate debt”

  1. Dear John,

    I’ve recently purchase your excellent book and trying to apply it.

    Have you given much thought to businesses using hidden debts by means of operational leases rather than outright purchase. I found reference to Phil Oakley’s article very helpful (https://www.sharescope.co.uk/philoakley_article42.jsp).

    As an example, when I applied this for Ted Baker, the view of company completely changes. It goes from having strong return on capital employed to average one (over 10 years).

    Consider the following numbers for year ending 31-jan-2019 (source sharepad):
    Post tax profit: £40.7m
    EBITDA: £79.9m
    Rental & lease expense: £96.2m
    Total Borrowing: £138.5m

    In this case the lease amount is a significant number.

    On one hand you’ve considered pension deficit conservatively and on the other totally skipped any consideration of lease expenses.

    Hence, it would be great to look at your views on this.

    PS: Your book is excellent and applies the investment principles in a long-term manner which makes complete sense to me.

    thanks in advance,

    1. Hi Toohey

      That’s a great question. So great in fact that I ended up writing a 500+ word reply which is far too long for a comment. I’ll answer much more briefly instead and just say that:

      1) I do not use capitalised lease obligations when analysing companies for several reasons, although I do think that calculating the present value of lease obligations is a good idea (and is becoming standard practice thanks to accounting standard IFRS 16)

      2) I will write up my answer as a blog post, probably sometime next week.

      1. Hello John,

        Thanks for your response. I look forward to reading your response.

        I was hesitant to capitalise since calculating present value of lease can be quite involved (and simple 7x is misleading) as there are likely to be multiple operational leases with different end dates. Plus It will be at least another year before the details of IFRS 16 will be felt.

        At the same time, I’m also concerned that the current lease payment (£96.2m) is a significant proportion of recalculated EBITDA (£176.1 = 96.2+79.9). I’ve found SharePad’s Fixed cover charge (EBIT + Lease divided by lease + interest ) quite interesting but limited since it uses EBIT. I’d rather use EBITDA based measure since that doesn’t rely on capitalisation.

        That would help understand the current liquidity risk as well as risk of dividend cut.

        However, the use of this additional off-balance sheet debt would still show the previous years’ invested capital and total borrowings lower than reality. This would give a much rosier picture of return on capital employed (however it is calculated).

        I’m hopeful that you’ll cover this aspect in your response as well. Obviously, I’m using TED as an example since it illustrates the issue well.

        Finally, may i suggest you to consider setting up automated reply once you (or someone) posts reply to comments. It is quite helpful and would mean one less thing for posters to remember. In may case, I only saw the reply because I came looking for it. It is possible this is already setup, but somehow I managed to miss it.

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