Thursday, June 13, 2013

The Next Dow? 25 Surprising Stocks, but look out below...

Do rising interest rates affect companies with high debt-to-equity ratio?

If you know what a debt-to-equity ratio is, you would likely say Yes, as it increases the cost of the capital you use to finance your business.  If your business uses debt to pay its current obligations, then uses next month's/quarter's/etc. revenue & profit to pay down that debt, you are pretty much:
  • Operating on a month-to-month basis, where a bad month could really hurt, and
  • Exemplifying the ancient Chinese proverb "Americans spend tomorrow's money today" (well, if you're not in America, it's still a dangerous game to play).
The Investopedia.com definition of the debt-to-equity ratio is:
A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.
Now, most smart businesses only use debt to finance aggressive growth and expansion, and taking on more debt might be a sign of really good things to come.  I can imagine lots of gun and ammunition factories looking to take on additional debt in order to expand their factories in the wake of the shortages (read: run on ammo by the Feds).  However, should something backfire along the way and revenue doesn't meet expectations, or a company begins operating on a month-to-month basis, rising interest rates will eat into whatever margins the company has left, negatively affecting earnings.

As interest rates have started to rise, I decided to take a look at the 25 publicly-traded companies with the highest debt-to-equity ratios in the United States.  They come from a variety of industries and include names you've heard of such as Orbitz, United-Continental Airlines, and DISH Network.  Some of these names have stayed on this list since last time I looked well over a year ago, and others have rotated on & off.  At first, one might think the prospect of rising rates would negatively affect the outlook of these companies and (by proxy) their prices, but the stock market doesn't seem to think so just yet.  I ran an analysis on 22 companies (as 3 of the 25 were in the pink sheets or otherwise not trading) comparing today's closing price with that of April 30, since 4/30 is where the TBT exchange-traded fund (tracking the yield on 20+ year Treasuries) had a recent bottom.  Here is the specific data:

Ticker Company Name Total D/E 4/30 Close Last
AVG AVG Technologies 2610 16.315 18.33
BXC Bluelinx Holdings 8460 2.93 2.44
CCK Crown Holdings I 2500 42.67 42.5
CHTR Charter Communica 9980 100.75 110.89
CSUN China Sunergy Co. 10260 1.55 1.98
DISH DISH Network Corp 3710 39.19 38.47
EDG Edgen Group Inc. 7750 6.86 6.97
EVC Entravision Commu 6020 3.86 5.47
FUN Cedar Fair L.P. 7360 42 40.4
GTIV Gentiva Health Se 3070 10.44 11.5
IMH Impac Mortgage Ho 19370 10.3201 11.11
LBTYA Liberty Global pl 2100 72.34 73.62
MNI McClatchy Company 5510 2.32 2.31
MNTG MTR Gaming Group 4170 3.45 3.71
OWW Orbitz Worldwide 3160 5.97 7.75
OXF Oxford Resource P 2920 3.268 2.55
RRD R.R. Donnelley &  7010 12.3 13.25
SLM SLM Corporation 3100 20.64 23.25
TPX Tempur-pedic Inte 7300 48.52 44.48
UAL United Continenta 12920 32.3 32.66
USG USG Corporation C 5790 26 26.05
WYNN Wynn Resorts Lim 2110 137.21 136.52

Correlations are near & dear to my heart, as you might have realized from previous posts, so here are some I'll present from this data (and others I didn't choose to paste in):

% Move to D/E 0.0447016
% Move to (Return on Equity / Market cap) 0.2689635
% Move to (Return on Assets / Market cap) -0.232323 

As you can see, these are not very compelling.  Since 4/30, the debt-to-equity ratio has not proven to be a useful indicator of stock performance at all, as the percent change for each asset in this group seems to basically be random.  Comparing the moves to various returns on equity or assets is a bit more correlated, but I wouldn't advise making any bets solely on any of these metrics nonetheless.

My final note pertains to the return on this basket: assuming you had one share in each company, you made 2.34% between 4/30 and now, or $15.01.  Coincidentally, in the same period, the Dow Jones Industrial Average has gone up 341 points, or 2.30%.  How long will this collection of stocks track the Dow so closely?  Will these start to crumble if & when interest rates on corporate bonds start to feel the same push as US Treasuries?  Only time will tell.  For now, don't buy any puts on any of these at random; some of these still would make great buys, but those who are squandering their debt will cease to exist, as 3 already have in recent memory.  To find out which ones will do what, I'll utter your favorite three words: "Do your research."  (Right up there with "Lose weight with proper diet & exercise.")  Hopefully this provided you with an interesting idea for how to play rising rates, even though nothing here is worth acting on just yet.

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