The potential for and timing of an interest rate hike is the source of endless speculation and presents several layers of potential fallout for highly leveraged companies, according to Validea CEO John Reese. In a recent article for The Globe and Mail, he discusses the various factors at play.
A wall of maturities: Rising rates could jolt the bond market. Jeffrey Gundlach of DoubleLine has said that “hundreds of billions” of corporate and high-yield bonds will be coming due around 2019 and, in the face of higher rates, “bond holders and the companies who have depended on low rates could be in for a big surprise” during rollover periods.
Too much debt undermines investor returns: Heavy debt costs can whittle away a company’s profit, so Reese advocates the approach he used when building his Buffett-inspired stock screening model. “Our model requires return-on-total-capital (net earnings divided by total debt plus equity) to be at or above 12 per cent.
Unsustainable cash outlays: Ultra-low interest rates, says Reese, have led to an unsustainable situation where cash outflows (including high dividend payouts and share buybacks) are surpassing earnings inflows. He referenced a comment in a recent blog by NYU professor Aswath Damodaran that “U.S. companies cannot keep returning cash at the rate at which they are today.”
Reese provided a list of companies that his guru-based strategies score highly due in part to low debt levels. Of those listed, Dril-Quip (DRQ), Sanderson Farms (SAFM) and Facebook (FB) earn the highest scores: