VALUE INVESTING
Debt – How Much is Too Much?

By Stephen Bland (TMFPyad)
September 22, 2000

A lot of discussion has occurred lately on the value shares board on the question of corporate debt. How much, if any, is acceptable to a value investor? It is a point which has occupied value players for as long as the concept has been around, which is pretty long because the style is quite ancient.

The question is personal to the investor, and there lies the difficulty in giving any meaningful views. In fact the whole definition of what constitutes a value share is personal to the investor, even within the broad definition of "cheap fundamentals" which we use on the value board.

I have described my personal approach, but I guess that few would follow it. For one thing my criteria are so demanding, deliberately, that it is only rarely that a suitable share appears. That makes life difficult for those who do not like to be out of the market for long periods. And for another, many good value investors use differing criteria anyway. For example we have discussed Price/Sales and Price/Cash Flow ratios recently, both well known value filters but not ones that I would generally consider, not because I am claiming they are inadequate but because I have enough already and too many is not necessary. Other value investors may for example disregard yield, to which I am quite fondly attached, like an old girlfriend who still drives you wild every time you see her.

Consequently value players vary both in the selection criteria they apply and the acceptable level of those criteria – that is, the point at which they decide that their particular filters exhibit value against whatever benchmark is being used. All the different approaches fit within the value concept of cheap fundamentals of some kind, and that is the common factor. The ultimate test of which ones form the best combination is the question to which we would all like an answer, but I suspect it is unanswerable. The reason I say this is that even two value investors buying on identical fundamental criteria would not make the same profit, or loss. Even if they bought at the same moment, they would probably sell at different points, exit strategy in particular being something that is often fairly subjective.

Returning to debt, my personal ideal is that the shares in which I am prepared to invest heavily have no debt at all, and preferably cash in the bank. In practice this often translates into what is known as "net cash". That is, debt exists in the company but it has also an amount of cash and near cash such that on balance, after deducting the debt from the cash, there is a positive balance of net cash available.

However, I am not saying that you cannot have value shares with debt. You can indeed, and the level of acceptable debt is something that individual investors must decide for themselves. For me, debt increases risk and the first things I look at in a value share are the risk-lowering factors, specifically the Price/Book ratio and the debt level. I consider these before I look at P/E, earnings per share forecasts or yield. My first question is always "how much can I lose if it goes wrong?", not "how much can I make if it goes right?"

Because I see all debt as adding to the risk, it follows that zero debt or net cash is the best level of debt desirable. Clearly though, it follows that a small level of debt adds only a small risk. For example gearing of up to 10% of shareholders' funds is not much to worry about whereas 200% would be, from a value point of view.

The reason debt adds to risk is that interest has to be paid on debt, whereas returns to shareholders in the form of dividends do not. A company that defaults on interest is in very serious trouble. But default apart, because that is rare, the more debt, and hence interest, payable, the greater the impact on earnings per share. The EPS is geared by the presence of substantial interest payments, such that a downturn in pre-interest profits will result in a correspondingly greater percentage downturn in EPS.

Of course it works the other way for an increase in pre-interest profits, but I am concerned here with minimising the downside, protecting myself as far as I can from something going wrong. And that obsession stems from my style of investing heavily in one share. Few adopt this approach, so value investors who have more holdings can afford to be less stringent about this, but even then I would rule out shares that have more than a modest level of debt.

As a bit of icing on the cake, shares which possess net cash or very low debt levels can be more attractive to potential bidders. Think about it: if you can buy a company and immediately recover some of the purchase price from the target itself, because it has cash, that is not exactly a negative point.

I always advocate that shares should never be bought on bid rumours, only on the fundamentals, but in fact the bid hopes come with the territory. A value share that is attractive to an investor may, for exactly the same reasons, be attractive to a bidder. Many of my successful past plays have been outed by a bid, or mug punter bid rumours, the latter being equally useful as an exit point.

So although I personally try to find my perfect play having net cash, there are a large number of good value shares out there which do possess some debt. If you are not playing the game my particular way, do not rule out an otherwise attractive share if it has a little borrowing.

Where Next?

• What is a "pyad share"?
• Value Shares discussion board