I spent a bit of time this weekend working the conclusions of a paper I have mentioned previously.
"Leveraged Small Value Equities" by Brian Chingono of the University of Chicago Booth School of Business and Daniel Rasmussen of the Stanford Graduate School of Business was released last year and I have been occasionally torturing their data and conclusions since then.
Their paper found that highly leveraged companies with certain characteristics are market beaters by an enormous percentage. The top stocks found under their methods average 25% a year between 1965 and 2013, albeit with a high degree of volatility. My own work shows that using this approach has continued to work very well since the end of the study period.
The paper looked for leveraged small-cap companies that had high gross profits to assets, low EV multiples and high free cash flow that had already started paying down debt. I ran screens looking for some current candidates and came up pretty dry. The few companies that did qualify had moved quite a bit higher in the past six months and I have a firm policy of not chasing stocks higher.
I considered the screen findings and had an epiphany of sorts. What would happen if I followed the advice of Charlie Munger and Blaise Pascal and inverted the criteria? Might I find some highly leveraged companies that could underperform and be worth selling or even shorting at current prices?
I searched for leveraged companies with low gross profits to assets and high multiples of free cash flow and EV/EBIT ratios. To make it a little easier to spot those that might run into significant financial difficulties, I also looked for those with low interest coverage ratios, indicating they may have significant problems making debt payments if they run into any sort of operating difficulties. The results give us a list of companies that we might consider selling on rallies if we own them and possibly putting in chicken shorts using long-term put spreads if we are the sort who does that kind of thing.
NCR (NCR) makes the list of potential troubled companies. It makes ATMs, point-of-sale devices, bar code scanners, inkjet and laser printer supplies and other devices that enable businesses to conduct transactions. It has been around since 1884 and was one of the first cash register companies. NCR is very leveraged with a debt to equity ratio of 6.64 and interest coverage is 0.8, so it is not covering payments due out of earnings right now. The price to free cash flow is not horrid at 11.8, but with and EV/EBIT ratio of 82, we cannot make any sort of case that the stock is cheap. Looking at the company, recent results and prospects, I cannot think of a single valid reason to own the stock at this level.
ClubCorp Holdings (MYCC) did pretty well following its debut in 2014 but has since dropped by about 50%. Looking at its financial condition and prospects, shares could fall a lot more in the future. ClubCorp owns and operates private golf, country, business, sports and alumni clubs in North America, and business is just not that great. The headlines may say record earnings but the record levels are still not that high.
The company is very leveraged with a debt to equity ratio over 7 and the interest coverage ratio is just 0.8, so it is not earning enough to cover payments. This means it is coming out of free cash flow and cutting into funds that should be being spent on capex and maintenance. The shares are priced at 28x free cash flow with an EV/EBIT ratio of 29.5, so you are paying a premium price for the business and the results do not come close to justifying the price tag. Living in central Florida, I can tell you firsthand that the golf industry is not what it used to be and I doubt it gets much better any time soon. The options are thin and it is not a great short candidate, as you would have to cover the 4% dividend, but I would be a seller if I owned the shares.
Seven years into a bull market that I think is richly priced as earnings are declining, it's as important to avoid stocks with poor fundamentals is it is to find undervalued securities that are too cheap not to own. Inverting the characteristics that make good leveraged value selections can help us avoid leveraged stocks where implosion risk is higher than normal.