Bank On Debt-Free Stock For Higher Returns

There are various myths when it comes to investing in equities. A common perception amongst the investors is that the debt-free stocks are the safest bet. Tanay Loya finds out whether debt-free stocks deserve a higher weightage in one's portfolio.

While participating in equity markets, one of the foremost dilemma faced by the investors is: “What strategy will work best in equity markets?” and “How does one beat markets, i.e Sensex or Nifty, consistently?” No matter what direction an investor takes, he or she is always looking for that extra edge that will provide the much-wanted extra returns.While the merits of value investing, contrarian investing, growth investing and momentum investing are well-documented, there is no clarity on the performance of a portfolio that primarily consists of debt-free companies. 

In other words, it would be interesting for investors to know how will a portfolio that includes primarily debt-free companies perform and, most importantly, whether it can outperform the broader market. Prima facie, it does make tremendous sense to construct a portfolio around debt-free stocks and hold on to such stocks for the long term. But do all debt-free stocks outperform? Which sectors have the maximum number of debt-free companies? It is important to understand the reality behind the debt-free companies before one can design a strategy for investing in debt-free stocks. 

Should one invest in debt-free companies? 

It is of paramount importance that any investor looking to construct a diversified equity portfolio has a predefined investment process and the investment process should define the stock selection process in detail. In our view, it is worth paying attention to the debt-free stock universe and the list of debt-free stocks should be whetted before selecting stocks for the portfolio. 

Looking at the performance of debt-free stocks, historically, we find that there is visible outperformance in the space and investors should take a note of it before finalising the list of stocks to be included in the portfolio. We see that there are nearly 397 debt-free stocks available for the investors in today’s market across various sectors. Majority of the debt-free stocks are available in sectors such as IT, capital goods, FMCG, healthcare, automobiles and auto-ancillary and in media and entertainment. 

In general, our data for those companies with market capitalisation of more than Rs 50 crore suggest that the debt-free companies across sectors put together have managed to generate return of nearly 29 per cent (average), while the average return for all those companies with debt on their books has been around 23 per cent in the past one year. 

Beta of more than one indicates the stock is more volatile than the market, while a beta of less than one indicates the stock is less volatile than the market. For example, a stock with a beta of 1.5 means it is 1.5 times as volatile as the market it is compared with. If the expected market return (Sensex) is 10% on an investment, we would expect the company to generate 15% returns. On the other hand, if the expected market return is -10%, investors in high beta stock should expect a return of -15%. If a stock has a beta of 0.5, we would expect it to be half as volatile as the market; therefore, a market return of 10% would mean a 5% return for the stock. 

For example, in the table below, we find that in the entire universe of the listed stocks on the BSE, there are almost 25 companies in the chemical sector that are debt-free. The average beta for all these 25 companies is 0.9 per cent. The average beta for all the 23 debt-free automobile and auto-ancillary companies is around 0.8 per cent. 

If we consider the average beta for all the 397 debt-free companies across various sectors, it works out to around 0.79. 

Prasanna Pathak

Fund Manager, Taurus Mutual Fund

Is it correct to say that debt-free companies outperform those stocks with higher debtto-equity ratio? 

It depends on the phase of the market that we are in. In a strong demand and capex cycle scenario, investors don’t mind companies taking debt on the balance sheet to achieve higher growth targets. A case in point is the 2003-2008 era, where new capex and acquisition plans by corporates were appreciated by investors even at the cost of leverage. The situation reversed when demand and capex cycle slowed significantly. 

Over a longer time frame, managements who are prudent in controlling the leverage are likely to create more wealth for shareholders. Also, businesses which structurally require less debt and throw up strong operating cash flows tend to create more wealth in the long run. 

How much weightage should be given to the debt-to-equity ratio while choosing a stock for a portfolio? 

It is an important parameter to monitor and analyse. Apart from the normal repercussions on the profit & loss (P&L) account, it provides critical clues about the nature of the business, nature of the management, capital allocation patterns and also insights into how well the company/business is doing currently. 

Which sectors normally have more debtfree companies? 

The fast moving consumer goods (FMCG) companies, information technology (IT) companies and consumer-facing companies with strong brands/products tend to have more number of debt-free companies.

Further we find that the debt-free companies have higher free cash flow available with them and hence these are able to distribute higher dividends. When we look at those stocks that are debt-free and distribute higher dividends, we notice that the average returns for such stocks is impressive. Below is the list of such top debt-free companies which have distributed dividends. 

However, we find that growth-oriented debt-free stocks have been able to outperform those stocks that are debt-free and distribute dividends, if we consider the data for past one year. We find that out of 397-odd debt-free companies, there are at least 120 companies that do not distribute dividends. On an average, these set of 120 debt-free companies that do not distribute dividends have delivered 42 per cent returns in the past one year, whereas debt free companies that have distributed dividends have managed to deliver 23 per cent returns (without adding the dividend income) in same time frame. 

Conclusion : 

Indian markets are on a song and with cash from retail investors continuing to flow into equities, the stability in equity markets is a given. Having said that, considering the volatile nature of equities, it always makes sense to identify stocks for investments that reflect lower volatility. By adding lower volatile stocks, any investor will improve his or her risk-adjusted returns. 

There is nothing better than a company showcasing decent growth and is debt-free. As an investor, it does make sense to identify quality debt-free stocks and stick with them over the long term. Historically, these companies have provided steady returns and have also reflected lower volatility. While focusing on debt-free stocks for investing, one must also keep in mind that not all debt-free stocks are good for investment and one must exercise utmost caution in identifying stocks from such a small basket of stocks. 

Investors should avoid holding on to bad stocks even if they are debt-free, because in investing, time is a friend of good stocks and an equally big enemy of bad stocks.