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From freedigitalphotos.net

This month’s theme relates to how one looks at debt in determining which companies are appropriate for one’s portfolio.  What originally started off as a pretty simple task, turned to an effort to make sense of what was going on.

It would seem obvious that companies with low debt should yield greater returns over time than those with high debt.  Harry Domash recommends a debt to equity ratio (D/E) less than 0.25, and sometimes 0.1; Peter Lynch wanted less than 0.8; Martin Zweig wants low debt compared to industry peers; and David Dreman wants the D/E to be less than 0.2.

The original strategy for this study was to determine the  annualized returns of stocks that had specific debt levels.  It was assumed by this writer that there would be a strong negative correlation, where as the debt levels increased, the annualized returns decreased.  In fact, as one can see, that did not happen.  The best we could determine was that companies which had a D/E less than or equal to 1.0 outperformed companies with a higher D/E.  While this result was significant, it was determined that it did not help the individual investor to funnel one’s results to find good solid companies that will yield a return in keeping with a “margin of safety” philosophy.

Debt Equity Returns

So how is one to streamline the search?  Try adding to the screen that the company’s D/E is equal to or lower than last year’s level.  Coupling that with a D/E level less than or equal to one, and it will generate a list of companies that will give one a sense of safety.  Add our previous concepts of profitable companies that pay a dividend, and a truly healthy list of companies begin to emerge that will perform well over time.  The final chart shows annualized returns of companies that have declining or growing debt levels.

Changing Debt Returns

Using the basic screen (from portfolio123.com) will give one a list of companies that have yielded an average of 11.42% since 1999.  The ten largest companies are listed here:

No Ticker Name Last MktCap EPS (TTM) Dividends (TTM) D/E (Previous Quarter) D/e (Previous Quarter One Year Ago) Price
1 Exxon Mobil Corp 88.66 390,281.34 7.96 2.34 0.05 0.05 88.66
2 Microsoft Corp 32.79 273,083.44 2.60 0.92 0.16 0.16 32.79
3 Johnson & Johnson 89.68 252,376.38 4.51 2.49 0.14 0.19 89.68
4 Wal-Mart Stores Inc 75.83 247,660.78 5.13 1.88 0.61 0.63 75.83
5 China Mobile Ltd 56.80 228,346.97 5.21 2.20 0.04 0.04 56.80
6 Wells Fargo & Co 42.85 227,197.42 3.69 0.99 0.82 0.91 42.85
7 Procter & Gamble Co (The) 79.39 217,713.33 3.87 2.29 0.28 0.33 79.39
8 Royal Dutch Shell PLC 65.89 207,421.72 7.52 3.48 0.16 0.16 65.89
9 HSBC Holdings PLC 55.14 204,475.00 4.13 2.30 0.97 1.13 55.14
10 Novartis AG 76.45 187,104.88 3.81 2.43 0.17 0.21 76.45

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