ederated
How ‘Strong Balance Sheet’ bias
is harming your equity allocation
Conventional wisdom says to invest in the stocks of companies with strong balance sheets
and avoid those with highly leveraged balance sheets. Many equity managers faithfully
follow this wisdom and tout the “we only invest in strong balance sheets” mantra.
Unfortunately, conventional wisdom is wrong; and unbeknownst to investors, this
strong-balance-sheet bias has been detrimental to their equity returns.
Leveraged company stocks have significantly outperformed the market,
yet mutual fund managers philosophically underinvest in them.
Gene B. Neavin, CFA
Vice President, Portfolio Manager,
Senior Investment Analyst
Gene Neavin is responsible
for portfolio management and
research in the fixed income
area concentrating in the
domestic high yield sector.
He joined Federated in 2001
and has 16 years of investment
experience. Previous associations
include Senior Credit Analyst,
MBNA America Bank. Gene
has a bachelor’s degree from
University of Delaware and an
MBA from Carnegie Mellon
University. He is also a CFA
charterholder.
Leveraged-company stocks – the stocks of companies with highly leveraged balance
sheets, i.e., high levels of debt relative to equity – have significantly outperformed their
less-leveraged counterparts over the short-, medium- and long-term.1 This should not
be a surprise. Modern investment theory states the greater the risk, the greater the
expected return.
Ironically, this overly-conservative strong-balance-sheet bias is pervasive in risktolerant equity portfolios but not in staid fixed-income portfolios. High-yield bonds
and leveraged loans (the debt of highly leveraged companies) are core allocations in
many fixed-income portfolios.
But there is good news for equity investors: a solution exists to offset this bias. A portfolio
of leveraged-company stocks can complement active equity allocations by providing
exposure to the most leveraged segment of the market, thus providing the potential for
stronger returns.
What is the ‘Strong Balance Sheet’ Bias?
Actively managed equity portfolios are biased toward strong balance sheets. They
overweight companies with strong balance sheets and underweight those with highly
leveraged balance sheets. This strong-balance-sheet bias is widely touted by equity
managers and sought by many investors.
The chart below shows that mutual funds underinvest in the most leveraged segment
of the stock market by a wide margin.
Mutual Fund Ownership of Stocks: Segmented by Balance Sheet Leverage
60%
Most leveraged stocks
50%
Leverage Ratio
Gene B. Neavin, CFA
40%
30%
20%
Least leveraged stocks
10%
0%
30
35
40
45
Average Number of Mutual Fund Holders
50
55
Source: CS U.S. Equity Strategy, eVestment, S&P Capital IQ/ClariFi; all as of 12/31/16. SMid Cap stock universe.
1
Source: Furey Research Partners.
Unfortunately for equity managers and their clients,
this strong-balance-sheet bias has been detrimental to
their performance.
As shown in the chart below, over the short-, medium- and
long-term, stocks of the companies with the most leveraged
balance sheets have significantly outperformed the stocks of
companies with less leveraged balance sheets.
Leveraged Company Stocks vs. Rest of Market
Average Annual Returns
15%
10%
5%
Trailing 10 Years
Trailing 15 Years
Trailing 20 Years
■ Most leveraged stocks ■ Rest of Market
Past performance is no guarantee of future results. For illustrative purposes only
and not representative of performance for any specific investment.
Source for Stocks: Furey Research Partners and FactSet as of 12/31/2016.
Universe: Small/Mid Cap universe is defined as stocks that fall between the
80th and 99th percentile of the aggregate market cap of all US stocks traded
on a major exchange, ex Financials Returns: Calculated by grouping stocks
within each sector by balance sheet leverage. Stocks with no debt were first
separated, then the remaining stocks were divided into leverage quartiles.
Leverage = Gross Debt / (Gross Debt plus Shareholders’ Equity).
Leveraged Company Stocks vs. Private Equity
15%
Average Annual Returns
Leveraged-company stocks have outperformed
strong-balance-sheet stocks
In fact, their performance has been so strong they have
even generated private equity-like returns, as shown in the
chart below.
10%
5%
Trailing 10 Years
Trailing 15 Years
Trailing 20 Years
■ Most leveraged stocks ■ Private Equity
Past performance is no guarantee of future results. For illustrative purposes only
and not representative of performance for any specific investment.
Source for Stocks: Furey Research Partners and FactSet as of 12/31/2016.
Private Equity: Cambridge Associates PE Index (net of fees) as of 9/30/16 vs.
Furey Research as of 09/30/16. Universe: Small/Mid Cap universe is defined as
stocks that fall between the 80th and 99th percentile of the aggregate market
cap of all US stocks traded on a major exchange, ex Financials Returns:
Calculated by grouping stocks within each sector by balance sheet leverage.
Stocks with no debt were first separated, then the remaining stocks were
divided into leverage quartiles. Leverage = Gross Debt / (Gross Debt plus
Shareholders’ Equity).
The outperformance of leveraged-company stocks should
not be a surprise. The Capital Asset Pricing Model (CAPM),
the foundation of modern investment theory, states that the
greater the risk of an investment, the greater its expected
return. So increasing a company’s financial leverage will
increase the risk (beta) of its stock, which in turn increases
the stock’s expected return potential. This principal is evident
across all asset classes, as shown below.
Average Annual Return (20 Yr)
This bias exists for many reasons. Leveraged company capital
structures are complex so require an in-depth understanding
of credit analysis, a skill not possessed by many equity
analysts. Also, many of these companies are in mature,
old-economy industries, not the sexy, growth-oriented
industries that Wall Street gravitates toward. And, there is
a negative connotation associated with “junk” credit ratings,
so they can be off-putting to many equity investors.
20 Year Risk/Return
14%
12%
Most
Leveraged
SMid Caps
SMid Caps
10%
High Yield
8%
US Agg
6%
Lg Caps
US Credit
4%
T-Bills
2%
0%
0
5
10
15
Standard Deviation (20 Yr)
20
25
Source: Morningstar Direct, Furey Research Partners as of 12/31/16.
T-Bills are represented by BBgBarc US Treasury Bills Index, US Agg is
represented by BBgBarc US Agg Bond Index, US Credit is represented by
BBgBarc US Credit Index, High Yield is represented by the BBgBarc US HY
2% Issuer Cap Index, Large Caps are represented by the Russell 1000 Index,
SMid Cap are represented by the Russell 2500 Index. Small/Mid Cap universe
is defined as stocks that fall between the 80th and 99th percentile of the
aggregate market cap of all US stocks traded on a major exchange. Leverage =
Gross Debt/ (Gross Debt plus Shareholders’ Equity). For illustrative purposes
only and not representative of performance for any specific investment.
A unique solution to offset this bias and
generate alpha
An allocation to leveraged-company stocks can complement
existing actively managed equity portfolios. Not only do these
stocks offset strong-balance-sheet bias, they also provide the
potential to generate alpha and stronger returns.
The leveraged-company segment of the stock market is
misunderstood and inefficiently priced by many equity
investors. Why? Not all leveraged companies are created
equal. A distinction must be made between “leveraged”
balance sheets that create equity value and “over-leveraged”
balance sheets that destroy it. In many cases the difference
is not obvious, necessitating a comprehensive and skilled
evaluation of a company’s entire capital structure.
High-yield credit analysts, who specialize in leveraged
capital structures, are ideally situated to exploit this
market inefficiency. By identifying debt catalysts that create
or destroy equity value before they become apparent to
equity investors, high-yield analysts can generate alpha.
Value-creating debt catalysts may include accretive
refinancings, de-risking through debt pay down and
shareholder friendly covenant amendments. Value-destroying
debt catalysts to be avoided may include bankruptcy triggers
such as maturity, liquidity and covenant issues.
Leveraged-company stocks explained
Leveraged-companies typically possess non-investment-grade
(aka high-yield or junk) or BBB (the lowest rung of the
investment-grade scale) credit ratings. Many investors are
familiar with leveraged companies through the leveraged loan
and high-yield bond asset classes. So leveraged-company
stocks are simply the equity, rather than the debt, of leveraged
loan and high-yield bond companies.
Leveraged Capital Structure
EQUITY
Private
Equity
(LBOs)
Public
Equity
High Yield Bonds
DEBT
Leveraged Loans
For many leveraged companies, high debt levels are an intentional choice, just as high debt levels are an intentional choice
in a leveraged buyout (LBO). Debt can create equity value
when used responsibly. It creates benefits for shareholders
such as tax shields, focused and efficient managerial discipline
and enhanced return-on-equity when things go well.
While it may seem counterintuitive, high debt levels can signal
business strength, not weakness. To obtain a high level of
debt at reasonable rates, lenders generally require a borrower
to possess many attractive business traits, such as stable and
predictable cash flows, leading and defensible market shares
and low reinvestment needs. Thus, it is important to make a
distinction between credit quality and business quality.
Securities issued by leveraged companies, including securities of companies that issue below investment grade debt or “junk bonds”, may be more volatile, be
more sensitive to adverse issuer, political, market or economic developments and have limited access to additional capital than securities of other, higher quality
companies or the market as a whole, which can limit their opportunities and ability to weather challenging business environments.
High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risks, and may be more volatile than investment grade securities.
Alpha measures the excess returns of an investment relative to the return of a benchmark index.
Q453706 (4/17)
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