Saturday, September 20, 2014

Why I Try To Avoid Debt

After reading this post by B from A Path to Financial Freedom Forever, I thought that I should explore and find some empirical reasons why I think that debt can be quite scary. It's always good to come across things that make you question why you are doing something in the first place. It helps keep your strategy sharp and allows you to better recognize the pitfalls that could appear as well.

Intuitively, it should make sense for leveraged companies to do better, especially since, as B rightly points out, cost of debt is much lower than equity. Debt used well is a very good tool in the toolkit that a companies management have to play around with. Empirically, the M-M principle backs up the claim as well.

Anyway, my first advice regarding debt comes actually from the famous Mr. Peter Lynch. I watched this a few months ago, and I really found some good nuggets of wisdom from him. (this is actually an awesome video, you should watch the whole things!)

 24.50 - 25.00
I learnt this very early... this might be a breakthrough for some people: It is very hard to go bankrupt if you don't have any debt. It's tricky. Some people can approach that. It is a real achievement.
Doing a quick search on Google with permutations of the words "low high debt outperform underperfom", I found a paper in 2010, that showed that the lowest decile of companies in terms of debt generally outperformed the market. The trend that they showed is that (excluding tech companies), most companies perform worse when they have more debt.


Strangely, the full data set including the tech companies showed that the highest debted companies performed very well too!

I actually find it strange to see data that shows that companies with more debt aren't performing progressively better than ones with no debt as the deciles move up. Lower overall cost of capital, leveraging for more returns, how is that possible for lower overall returns? Even from executing simple trades on margin, we know that leverage can amplify returns. Of course, we all also know from common sense that too much leverage is quite dangerous and risky. From the Jacques Lussier book that I read, the reason why more leverage isn't necessarily better, is because it destroys and skews your risk-reward ratio. Although minimal at low debt levels, the more debt that is piled on, the more downside risk is being adding, much faster than the upside risk. However, the book does support that it can be good to use some leverage still.

Another book that I read, Investing in REITs, Chapter 8, had the author explicitly admit that he does not know why REITs tend to have gearing at around 40%. His own views that was gearing does not significantly improve returns and he is indifferent to gearing levels below that of 40%. However, he does say that higher gearing (over 55%) can be a cause of concern.

Perhaps (but I am not sure, I can only speculate), not all companies are good allocators of capital.

Having lines of credit allows companies to make the most of opportunities and capitalize on good deals. On the flipside, it might also encourage people to bite off more than they can chew. Interest expenses will become a recurring expense regardless if the investment succeeds or flops.

Just like how some debt is good you, individuals who are good capital allocators know how to use credit cards well. Example: free financing (amount due is payable next month) and extras (rebates and rewards). For companies, I think that examples of good liabilities to have are trade payables and deferred tax liabilities.

I think that choosing to invest in companies based on debt levels is more based on preference and style rather than facts, since the jury is not out yet that shows clear evidence that different debt levels would give different returns. To say across the board that one should avoid companies with debt is too big of a generalization. The same way it is to say that companies with no debts are great investments. Perhaps a better way of saying it is, it depends on the situation on a case by case basis.

That being said, if I do see a good company that is going to take up debt, that will definitely not stop me from considering them. As long as I can feel that what they are doing is taking advantage of a good situation, I will quite gladly continue holding on to them. Many companies do ramp up their debt doing opportunate times, then slowly pay it down back to healthy levels. 

Anyway, it is just my personal belief that, as Peter Lynch said, that it is very hard for companies with no debt to go bankrupt. So although very low debt companies may (intuitively) not give as much returns as their more leveraged counterparts, I feel safer and more comfortable owning them as a business. Value, quality, shareholder yield and financial strength are just my personal pick of factors that I choose to invest based on.

2 comments:

  1. Hi GMGH

    Thanks for debating. I like the arguments you put out there.

    I think we always need to assess whether debt equals to high returns just as whether taking on risks warranties higher return. Does taking on more debt necessarily equal to higher risk out there?

    I think its fair that you mention it depends on one risk assessment and profile but as you correctly points out an individual should understand debt better and if they are managed well they can be a good tool to hv. I personally know someone who is always using leverage and are always assessing the risk resulting from it. Proper management equals greater everything. But one should understand debt a little better.

    P.s I will add you to my link of blog list. I think you are a very educated person and provide good assessment :)

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    Replies
    1. Hi B,

      No, thank you for the article to make me think about debt!

      Does taking on more debt necessarily equal to higher risk? From a stock perspective, I think most people would say yes, because now more claims are on the total assets, and there is a cost to debt. However, from a business perspective, actually not taking up debt to do investing/acquiring/expanding might put the business itself at risk of competition and sustainable profitability in the future. But if debt is taken on to increase the management salaries.... I will run away, haha!

      I think the example that you gave regarding how Howard Marks view market risk is quite paradigm changing for me to also apply and look at debt in a new way as well. I'll now look more closely at what debt they have and why they took on the debt, I think that analysis would give useful information about the stock although it is one layer deeper than the simple D-E ratio or debt ratio!

      PS. Thanks for the kinds words, you are in my links too!

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