Stocks Reducing Debt & Earning Abnormal Profits

Prior Management Behavior & Outcomes
Momentum, Credit Quality & Size, Helping Identify Future Outperformers
Putting It All Together: Stock Selection

Prior Management Behavior & Outcomes

As explained in Part I of Activism Lite, we believe that the correlation of debt reduction with high excess returns creates a credible construct for investors to pursue with corporate management. This combination seemed particularly effective when paired with valuation as defined by FCF/EV. Our findings show that ultimately a company’s willingness to pay down debt may signal confidence in the sustainability of profits. When corporate management at high-debt firms create narratives infused with earnings growth based on synergy-rich acquisitions or product expansions, investors may be wise to consider the potential benefits of debt reduction instead.

While we believe that simply working in the least expensive component of the FCF/EV universe among high-debt companies and attempting to find stable cash flows and friendly management is an excellent idea, we decided to try shrinking the universe of stocks while improving efficacy. We began the research process with the idea that firms that had reduced (or added) debt in the prior year might be an excellent signal as to what their managements intended to do in the current year. Our analysis did not disappoint.

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In Fig. 1 below, we show the distribution of firms based on their prior-year’s change in debt. Firms that reduced debt in the prior year were much more likely to reduce debt again (ending up in tercile one), while firms that added the most debt in the prior year were far more likely to add debt again.

Figure 1 – Companies that Pay Down Debt Are More Likely to Do So Again

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ADDITIONAL READING

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