What's the warning signal that a declining share price has gone too low to be a buy?
I have been struck by some very strong positive feedback recently. No, not for my articles, but in the share prices of distressed companies. As Taylor Wimpey (LSE:TW.), Barratt Developments (LSE:BDEV), Bradford & Bingley (LSE:BB.) and Northern Rock were accosted by financial gravity, debt solidifying around their feet, their falling prices became added millstones.
At this part of the economic cycle, huge rights issues are once again in vogue. They are effectively debt for equity swaps; the only question is the degree of pain (loss of cash or loss of earnings per share) that shareholders are asked to forbear. HBOS (LSE:HBOS) had raised £4bn, or 21% of its capitalisation on the day before the rights issue announcement. Shareholders were asked to buy two shares at 275p for every five they owned. The City didn't like it but it was medicine it could swallow.
If HBOS's share price had already fallen to say 100p rather than 500p, the bank would have been worth only £3.75bn, or less than the amount they needed to raise. HBOS would have to have issued 7.5bn new shares at say 53p, a three times dilution. The institutions would have baulked at such a figure, and securing an underwriter willing to take the risk of being left with 7.5bn shares would have been doubtful.
The Cap's Too Small To Fit
So should we avoid all companies with high debt relative to market capitalisation? No – this ratio only matters if the company is at risk of a cash crunch, and more so in times of economic stress.
A trawl of companies with very high debt to capitalisation throws up mainly financials – banks, life insurers etc. I'll ignore these since analysis of their balance sheets is what Warren Buffett calls 'too difficult'. Setting a minimum capitalisation of £50m, these two likely lads have the highest net debt to capitalisation with low interest cover:
| Share | Share
price (p) | Net
debt (£m) | Net debt
to market
cap /£m | Interest
Cover |
|---|
| Avis Europe | 13.25 | 692 | 5.7 | 1.5 |
| Yell Group | 79 | 3759 | 6.1 | 2.2 |
Whilst Yell Group has higher net debt compared to its capitalisation, Avis is clearly financially weaker and has less pricing power. I looked at this car hire outfit in 2002 as a post-911 recovery play, but the profitability has declined almost every year. Its ratios are truly dreadful and it gets a prime parking spot in my WNTB table.
Here’s the WNTB table to date. Cost is the best quote from an online broker.
Buy date | Company | Cost
p | Now
p | Gain/
(Loss) % |
March | Griffin Group (LSE:GFF) | 2.5 | 0.625 | (75) |
April | British Airways (LSE:BAY) | 507 | 235 | (54) |
May | Patientline (LSE:PTL) | 4 | 0 | (100) |
June | Coffee Republic (LSE:CFE) | 3.37 | 1.025 | (70) |
July | Manganese Bronze (LSE:MNGS) | 864 | 314 | (64) |
August | Victoria Oil & Gas (LSE:VOG) | 37.9 | 9.5 | (75) |
November | Northern Rock | 150 | Delisted * | (??) |
December | iShares China 25 (LSE:FXC) | 7765 | 6544 | (16) |
February | Netstore (LSE:NES) | 23.7 | 22.75 | (4) |
March | London Town (LSE:LTW) | 170 | 137.5 | (19) |
May | Playtech (LSE:PTEC) | 543 | 503 | (7) |
June | Coms (LSE:COMS) | 0.55p | 0.4 | (27) |
July | Avis Europe (LSE:AVE) | 13.49 | | |
Warning: this is not a portfolio of companies to short sell. Luck, speculation and the distinct possibility that I may be plain wrong may send values up sharply.
* The Government will announce shareholder compensation (if any) for the nationalised Northern Rock. It is likely to be a small amount.
Alun has a short position in Manganese Bronze
