When Debt is more than a Four-Letter Word

The expert consensus is so strong on the dangers of financial leverage that investors should not be faulted for thinking of debt, first and foremost, as a four-letter word.

Benjamin Graham wrote that corporate debt is “an economic factor of some magnitude and a real problem for many individual companies.”  The Oracle of Omaha avers. “I do not like debt and do not like to invest in companies that have too much debt.”  Even our philosopher kings at the Federal Reserve have weighed in, pontificating that debt “in excess of 6X Total Debt/EBITDA raises concerns for most industries.”

It might shock you to learn that the portfolio manager of the Verdad Leveraged Company Fund and the anti-expert gadfly author of the Verdad Weekly Research note agrees, but with a very important caveat, a caveat on which the whole Verdad investment strategy hinges.

Let me explain.

We can think of adding debt to a corporate balance sheet as having two separate impacts — a beta impact and an alpha impact.

The beta impact is that the debt acts to amplify the volatility of the equity valuation. If a company is leveraged 90%, and the value of the company increases 10%, the equity value of the company doubles. And the reverse effect occurs if the value of the company declines.

The alpha impact is that debt changes the ratio of distributable free cash flow to market capitalization, both by adding interest payments that reduce free cash flow and by reducing market capitalization relative to an unleveraged company.

For about 86% of companies, the negative impacts of increased interest payments outweigh the positive impacts of reducing market capitalization, proving Graham, Buffett, and the Federal Reserve’s instincts correct.

We illustrate this in the chart below. On the x-axis, we divided the ~10,000 small cap companies in the world by valuation and then by leverage level on the y-axis. More expensive, less indebted companies are in the top left, while cheaper, more indebted companies are in the bottom right. This chart shows free cash flow yield to equity (i.e. cash from operations less cash from investing divided by market capitalization).

Figure 1: Free Cash Flow Yield Varying by Valuation & Indebtedness

Source: CapitalIQ

Valuation always has the same impact on free cash flow yield, moving from left to right on any row in the table, free cash flow yields rise. This is an obvious relationship: lower prices mean higher yields.

And for the first three columns, debt appears to have a similarly consistent effect. Moving from top to bottom, increasing the ratio of debt to enterprise value, reduces free cash flow yield. This is because more debt means higher interest payments which means less free cash flow.

But on the far right-hand column, representing about 14% of global market capitalization, we see a reversal of the impact of leverage. Here, more leverage increases free cash flow yield!

In the cheapest two deciles of the global stock market, leverage adds positive alpha in addition to increasing beta exposure — it’s like adding N2O to your car’s gasoline tank. Combining leverage and deep value produces rocket fuel for equity returns.

This was the secret to the roaring success of the LBO industry in the 80s and 90s.  This is why we are so militant about valuation. And this is why we are so critical of the high prices and high leverage levels of most private equity deals today.

The expert consensus about leverage, in sum, is right for about 86% of the market.  If you look at the broader equity markets and study leverage as a factor, you’ll see increased beta and negative alpha. But if you restrict your study to the cheapest stocks, the effect reverses, and it is here, in this narrow corner of the market, that Verdad invests.