One potential way to find stocks of smaller companies with a greater potential for capital appreciation is to look at long-term debt. A reduction in long-term debt along with a low valuation and an improvement in asset turnover are linked to better stock price performance.

Before getting into the details of this strategy, which is proposed in a new working paper, I want to discuss debt from an investor’s perspective. Corporate debt is a double-edged sword. It can put a company at increased risk, limit growth and restrict future dividend payments and share repurchases. Debt can also be an effective way of financing potentially profitable endeavors (e.g., the construction of a new plant) and managing both cash flow and tax liabilities.

The key with debt is determining the ratio of liabilities to equity, how the debt is being used and whether debt is increasing or decreasing. Companies with rising levels of debt should not necessarily be ruled out; rather, an examination of what the debt is being used for needs to be conducted. Read through the company’s quarterly reports, conference call transcripts and annual reports to determine the plans for using the debt.

The working paper’s authors looked to private equity in creating their approach. It is not uncommon for private equity firms to utilize debt to pull money out of a purchased company. In simplistic terms, private equity firms seek to outlay as little cash as possible when buying and operating a company in order to maximize the yield (dollars received divided by dollars spent) on their investment. The paper's authors say a similar approach can be utilized for targeting publicly traded companies with smaller market capitalizations.

They suggest focusing on companies whose market capitalizations rank between the bottom 25% and the top 75% of all exchange-listed companies. The largest of these companies are near the border between the S&P MidCap 400 and the S&P SmallCap 600 indexes. The authors further suggest seeking stocks with an above-median level of debt and trading at valuations ranking in the cheapest 25% of value. (Companies ranking in the bottom quartile of size were excluded because the authors believed they are too small to be of interest to institutional investors. I don’t see a reason why the approach discussed here wouldn’t work with exchange-listed micro-cap companies, however.)

Debt is measured as long-term debt relative to enterprise value. Enterprise value (also referred to as total capitalization) is market capitalization plus long-term debt. It considers all aspects of financing (debt and equity) as opposed to market capitalization, which just considers equity financing. (Market capitalization is the number of shares outstanding multiplied by the current stock price.)

Value is defined as EBITDA/EV, which is earnings before interest, taxes, depreciation and amortization divided by enterprise value. The study’s authors felt that this measure incorporates more recent information than the price-to-book ratio. It would have been good to see the study replicated with other valuation measures to see if the strategy holds up; I would be surprised if this is an anomaly that only exists with EBITDA/EV.

Since the levels of assets and liabilities vary across companies and industries, the authors specified two measures to identify quality companies. The first is debt pay-down. This rewards companies for having less long-term debt this year than last year. The score is calculated in a binary fashion—either a company reduced its long-term debt or it didn’t. The second measure is year-over-year improvement in asset turnover. Asset turnover (sales divided by average total assets) measures how much revenue was generated from a company’s assets. To improve the ratio, a company either needs to grow sales faster than its assets or reduce the proportion of assets relative to its sales (implying greater efficiency).

A few final observations about this strategy. The authors sought to take advantage of both the small company size and value premiums. (Both small company size and low valuations have been shown to positively impact long-term returns.) They then overlaid quality factors to only focus on those companies with improving fundamentals and eliminate those companies not paying down their debt and either not growing or simply not operating more efficiently. In other words, while the approach is unique, the basic framework is not: Seek out good, smaller-sized companies that are trading at attractive valuations.

• 16 Financial Ratios for Analyzing a Company’s Strengths and Weaknesses – Asset turnover and debt-to-equity are just two of the ratios you can use to assess a company’s underlying financial strength.
  
• Exploiting the Relative Outperformance of Small-Cap Stocks – The small-cap stock premium has been most evident during periods of economic expansion.
  
• Do You Consider Debt When Analyzing a Stock? – Tell us on the AAII.com Discussion Boards
  

Only 16 members of the S&P 500 are scheduled to report their quarterly results. Retailers, including Macy's (M), will begin announcing their earnings. The only Dow Jones industrial average component on next week’s schedule is technology giant Cisco Systems (CSCO). Both Macy’s and Cisco Systems will report on Wednesday.

On the economic front, second-quarter productivity and cost data will be released on Tuesday. Wednesday will feature the June Job Openings and Labor Turnover Survey (JOLTS). July retail sales, July import and export prices and June business inventories will be released on Thursday. Friday will feature the July Producer Price Index (PPI), July industrial production and capacity and the University of Michigan's preliminary August consumer sentiment survey.

Two Federal Reserve officials are scheduled to speak: Atlanta president Dennis Lockhart on Monday and New York president William Dudley on Wednesday.

The Treasury Department will auction $24 billion of three-year notes on Tuesday, $24 billion of 10-year notes on Wednesday and $16 billion of 30-year bonds on Thursday.

The proportion of individual investors describing their short-term market expectations as neutral rebounded back above 40% in the latest AAII Sentiment Survey. The change occurred as pessimism pulled back after nearly hitting a two-year high last week.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 3.2% percentage points to 24.3%. The increase follows what had been a seven-week low. It is not large enough, however, to prevent optimism from being below its historical average of 39.0% for a 22nd consecutive week, the longest such streak since a 29-week stretch in 1993.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, jumped 5.8 percentage points to 44.0%. The increase keeps neutral sentiment above its historical average of 31.0% for a 31st consecutive week.

Bearish sentiment, expectations that stock prices will fall over the next six months, pulled back by 9.0 percentage points to 31.7%. The drop follows last week’s large upward spike. Even with the decrease, pessimism is above its historical average of 30.0% for a second consecutive week and the fifth time in the past nine weeks.

Bullish sentiment is at an unusually low level (below 28.5%) for the fourth time in six weeks. Neutral sentiment, conversely, is back at an unusually high level (above 39.6%) for the 17th time in 18 weeks. Both unusually low optimism and unusually high neutral sentiment have been correlated with above-median returns for the S&P 500. (There is no guarantee that history will repeat.)

Though there have been notable swings in bullish and bearish sentiment over the past two months, pessimism has generally been higher relative to the levels registered over the preceding 12 months. A bigger constant has been neutral sentiment, which is now just shy of matching the record for the most consecutive weeks of above-average readings (32 weeks).

Giving AAII members reasons for caution are concerns about the possibility of a sizeable decline in stock prices occurring, the pace of economic growth, the lack of wage growth, valuations, the impact of the stronger dollar on earnings and geopolitical events. As this week’s special question indicates, the lack of market breadth is a factor for some individual investors as well. Keeping other AAII members optimistic is the Federal Reserve’s still-accommodative monetary policy, the ongoing bull market, sustained economic expansion and earnings growth.

This week’s special question asked AAII members about how concerned they are about a small number of stocks driving this year’s gains in the S&P 500 and the NASDAQ. Nearly 44% of respondents said they are either concerned or very concerned about the lack of market breadth. Several viewed it as a negative signal about the market’s future direction. Slightly more than 15% said they were somewhat concerned about the lack of market breadth. Nearly a third of all respondents (32%) said they are not concerned or are only slightly concerned. Several of these members said they are either more focused on the performance of their portfolios or that they follow a long-term approach.

Here is a sampling of the responses:

• “I believe it’s very concerning. It’s not a very good sign.”
• “This concerns me very much. It looks like a top to the current market high.”
• “It is a concern because it skews the results. Hard to tell what is happening elsewhere.”
• “None at all. I focus on individual stocks and each company’s performance.”
• “Not much breadth to the market, but being a long-term investor, I am not as concerned with short-term gyrations.”

Bullish: 24.3%, up 3.2 points
Neutral: 44%, up 5.8 points
Bearish: 31.7%, down 9.0 points


Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%

Higher levels of stock market volatility did not cause many individual investors to alter their portfolio allocations, according to the July AAII Asset Allocation Survey. Rather, allocations among stocks, bonds and cash changed only modestly.

Stock and stock fund allocations rebounded by 0.2 percentage points to 67.4%, following modest declines during the previous two months. The small increase resulted in stock and stock fund allocations staying above their historical average of 60% for the 28th consecutive month.

Bond and bond fund allocations were essentially unchanged for the third consecutive month, holding steady at 15.5%. As was the case in June, the changes in bond fund and bond allocations were very minor (and largely unnoticeable after the results were rounded). July was the third consecutive month with fixed-income allocations below their historical average of 16.0%.

Cash allocations edged down 0.1%, to 17.2%. This was the first time that cash allocations stayed above 17.0% on consecutive months since March 2014 through June 2014. Last month was the 44th consecutive month with a cash allocation reading below its historical average of 24%.

The increased volatility in the stock market and the corresponding weekly swings in our Sentiment Survey did not result in many changes being made to the portfolios of AAII members. Though some members are concerned about the possibility of a sizeable decline in stock prices occurring, many remain frustrated with the continuing low level of interest rates.

Last month’s special question asked AAII members what, if any, allocations they expect to make during the second half of the year. Responses were mixed. The largest group, representing 28% of all respondents, did not anticipate making any changes. Many of them said they are following a long-term strategy. Nearly 20% of respondents expect to shift money into stocks or stock funds, particularly if there is a notable market drop. About 12% of respondents expect to boost their cash holdings, while 11% think they will reduce the amount held in cash. Approximately 10% say they will increase their fixed-income holdings. Several members said they may reallocate within a given asset category, with several mentioning the possibility of increasing exposure to international stocks.

Here is a sampling of the responses:

• “Any changes made to allocations will depend on what the market does.”
• “I expect to make no significant allocation changes during the balance of 2015.”
• “Use cash to purchase stocks upon any significant market correction.”
• “Slowly increase bond holdings, including funds.”

• Stocks and Stock Funds: 67.4%, up 0.2 percentage points
• Bond and Bond Funds: 15.5%, no change
• Cash: 17.2%, down 0.1 percentage points

• Stocks: 33.0%, down 0.6 percentage points
• Stock Funds: 34.4%, up 0.9 percentage points
• Bonds: 3.7%, down 0.1 percentage points
• Bond Funds: 11.8%, no change

Take the Asset Allocation Survey.

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