In the search of Goode value we must be willing to take necessary risks. We must be willing to bet on struggling companies, sometimes with bad management, sometimes in struggling industries. We must never combine those three, however. Most important of all, we must shun excessive debt like the plague. While I prefer to avoid companies with significant debt, in cases in which the company has consistent earnings and the ability to maintain those earnings (because of strong brands or monopoly status), debt is forgivable.
For companies with tough competition and little competitive advantage, debt is a very, very bad idea. Two great cases in point are Movie Gallery (MOVI) and General Motors (GM). Both companies have historically strong brands and decent business models. They are both extraordinarily cheap. If they had less debt they would be great companies to buy. Saddled with debt, however, they lack the ability to survive their cut-throat industries.
Movie Gallery is a great example of stupid management harming a company. The company’s stock traded as high as $30 in 2005; it now trades at $0.55. Movie Gallery runs a chain of video rental stores. They have historically been profitable. However, early in 2005 the company took on much debt to buy Hollywood Video. The company now has a market cap of $17 million and debt of $1.1 billion. The company’s bankruptcy is imminent. I would argue that the movie rental business is one of the best businesses to be in. People like watching movies, new movies cost a lot to see at movie theaters, and the competition (satellite and cable movies on demand) are not that great.
While Netflix (NFLX) has made it harder for bricks and mortar stores, I feel its impact has been drastically over-rated. I subscribe to the Netflix service, but there are plenty of people who do not. A bricks and mortar store can do good business because those that rent more infrequently will never subscribe to a Netflix-type service. Therefore, I think that Movie Gallery’s two chains, Movie Gallery and Hollywood Video, will still be around in one form or another fifteen years from now. The problem is that the debt of the current company will prevent it from responding to challenges. Bankruptcy is therefore almost certain
General Motors faces much the same problem. Unfortunately for the careless investor, their full debt his hidden in details in their financial statements about their union contracts and the number of retirees for whom they provide pensions. Some have estimated that GM will have to pay out over $70 billion in pensions and health care benefits to its current and future retirees. For a company that has consistently lost a few billion dollars per year over the last few years, this is a problem. In addition to its debt, GM has too many brands, too much production capacity, an unfavorable union contract, and shrinking sales. Without such a sizable debt, GM would stand a chance of restructuring and saving its stockholders. As it stands, it has no room to maneuver. Unless it can become highly profitable within a year or at most two years, it will go bankrupt.
So does debt matter for stock returns? Yes, at least according to this study (scroll down on the page to which I link to download the PDF). While the data are from the UK, the results are logical and should apply in the USA as well. While the correlation of debt ratio with stock returns is lower than the correlation of P/E with stock returns, there is still a definite negative correlation: the stock of those companies with the least debt did the best. The 30% of companies with the lowest debt showed a consistent advantage over those with higher debt. Those companies had leverage ratios of under 20%, meaning that total debt represented less than 20% of enterprise value. For comparison, MOVI has a leverage ratio of 99%, while GM has a leverage ratio of 96%.
Disclosure: I have no interest in any company mentioned. Since I wrote this article last spring both GM and MOVI have seen their stocks decline. MOVI looks like it is about to enter bankruptcy. I have a disclosure policy.