Debt = Danger?

If you think D/E ratio of 1 is fine, think again! My study on Nifty 50 companies (excluding NBFCs and banks) shows that no company having debt-to-equity ratio of more than one gave positive share price returns in the last one year.

If you think D/E ratio of 1 is fine, think again!

My study on Nifty 50 companies (excluding NBFCs and banks) shows that no company having debt-to-equity ratio of more than one gave positive share price returns in the last one year. The companies whose debt moved up with poor financials performed the worst, like Bharti Airtel whose debt moved up from Rs 1 lac crore as of March 2016 to Rs 1.15 lac crore in September 2018 or Tata Motors, whose debt increased from Rs 70000 crore to Rs 92000 crore during the same period. Both these companies have struggled to report growth in their bottom lines. On the other hand, companies like TCS and Hindustan Unilever did well on the bourses as they have no debt and have good amount of liquidity in the balance sheet. Look at the table below that shows best returns in last one year came from zero debt companies in last one year.

Only exception to this rule is Reliance Industries, whose debt has increased from Rs 1.94 lac crore to Rs 2.34 lac crore as it did huge capex on the Jio business. Despite this increase in debt, its debt-equity ratio continues to be less than one. Since the company’s commodity business is generating big cash flow, investors are not worried too much about its debt levels. They would start worrying the moment it crosses the ratio of 1.

What’s wrong?

In the last one year or so, one distinct pattern has emerged. Investors have developed apathy towards companies carrying higher debt. On top of it, if promoters’ shares are pledged, then it becomes a strictly ‘no go’ area.

While concern on pledged shares was aired in the past, it has gained more importance recently after the Zee episode. Before the Zee incident, pledged shares were not considered as a problem area in good quality companies as investors took comfort in the fact that the company had strong financials and the stock price movement was steady. But the Zee episode has revealed that when investors start selling shares, they don’t look at the financials or the PE the company is commanding. They are in a rush to move out.

New set of investors don’t come in even at the lower price to lap up the shares, suggesting that the valuation premium the company used to command has diminished. The damage is done and it remains. With no circuit limits on the share prices of large companies (as they are in the F&O segment and hence, technically, they can fall as much as 99 per cent in a day), those who lent money against the pledged shares get jittery. They sell shares to protect their interests. As a result, the slide continues.

Zee Group acted swiftly and managed to arrest the slide further as the Group did an agreement with the lender and bought time till September 2019. The verdict is not yet out whether it is a temporary relief or a permanent one. In case the company’s financials in the next two quarters don’t live up to investors’ expectations, the bear cartel can and will exploit the situation.

This episode holds lessons for the investors. The standard debt-equity ratio of 2:1 is passé. In today’s changing business environment, things are moving much faster than in the past. Not many companies are able to adjust to the new paradigm. In the process, the company’s financials suffer and then the debt-equity ratio keeps rising, and a stage comes when the company is not able to repay the debt and defaults.

Take the case of Reliance Communications (RCom)—the Anil Ambani Group company—which recently moved the NCLT for its debt resolution. RCom four years back had debt-to-equity ratio of less than 1. But Jio’s entry changed the business model for telecom companies. RCom could not compete. The company’s financials moved from profits to losses. Denominator shrunk and numerator increased. Investors lost money big time. What can happen to RCom can happen to any company.

What’s the solution?

Simply this – even if a company has debt-equity ratio of 1:1, investors should study the company’s financials closely. With global uncertainties and the fast-changing pace of technology, many businesses may not be able to service even 1:1 debt-equity ratio. If you wish to play ultra-safe, then buy companies that are debt-free or have a negative debt (means they carry higher liquid investments than debt in their balance sheets). These companies would be in a better position to take on the competition due to their better fighting prowess, and stable balance sheets.

Investors pay higher premium if companies are debt-free or have negative debt. What is looking costly may continue to remain costly as such companies are scarce. Companies with zero debt and no mortgage of promoters’ holdings are tough to find.

Despite the leading stock indices trading close to all-high time levels, the market sentiments continue to remain weak. Every day there are more declines than advances. In this kind of market, I would prefer to park my hard-earned money in companies where profits are increasing with zero debt and promoters have no pledged shares. If these three conditions are met, I would zero in on these companies. If valuation is found reasonable, I would add the company in my portfolio. I would suggest a similar strategy for investors too.

Sunil Damania
Chief Investment Officer – Marketsmojo.com

 

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Disclaimer: This blog is only for education purpose. We don’t give buy or sell call on any company. All investors are advised to do their independent research and/or consult their financial advisor.

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