Using Debt to Find Attractive Small-Cap Stocks

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.