Stock investing: Cull overleveraged companies from your portfolio

At a time when revenues have been disrupted, these are the ones that could go belly up first

Warren Buffett once quipped that it is only when the tide goes out that you discover who has been swimming naked. When business conditions are easy and favourable, the stock prices of all sorts of businesses run up on the bourses.

But when the climate turns harsh, as it has currently due to the Covid-19 induced lockdown, the spotlight gets focused on businesses with flawed models.

With revenues drying up, the companies that will struggle the most in the coming days and may even go belly up are those that have resorted to heavy use of leverage to fuel their growth.
 

The YES Bank example: Prior to the outbreak of the pandemic, retail investors bought stocks of YES Bank like there was no tomorrow. During Q3 and Q4 of FY20, while YES Bank’s top management was selling its holdings, retail investors were buying on all dips. They were buying only because the stock price was falling — not because they understood YES Bank’s business model or anything of that sort. They were buying simply on the hope that one day all would be fine and they would be rewarded handsomely for the risk they had taken. When the State Bank of India (SBI) came in as a white knight and rescued YES Bank, these investors had the “Look, I told you so” expression on their faces.
 

What they did not realise was that things could very easily have gone wrong. Punting with such overconfidence can lead to massive losses. The list of fallen heroes is much longer than that of rising phoenixes. Suzlon, JP Asssociates, Kingfisher, Amtek,
 

R Com and many more have time and again dashed the hopes of retail investors who bet on them expecting to become millionaires overnight.
 

Watch out for leverage: Identifying stocks can be a challenging task and an entire industry filled with the sharpest minds is engaged in doing just that day after day. Nonetheless, a retail investor can exercise a few basic precautions that can offer him a cushion against portfolio bleeding.

Among the first financial parameters that an investor should look up is a company’s (excluding banks and non-banking financial companies) level of debt.
 

All the fallen heroes listed above are guilty of committing the same mistake — taking on a high level of debt. As long as companies avoid falling into a debt trap — which essentially means that whatever they earn ends up being paid as interest and when the situation gets worse, they are forced to take more debt to service or repay existing debt — they can be considered by retail investors for further examination.

But if a company’s debt level exceeds its net worth, retail investors should simply delete that name from their list of probable portfolio candidates. If they have such a company in their portfolio, they should simply exit it the next time the market opens. Sticking to this one simple parameter will at least prevent retail investors from having potential time bombs in their portfolios.
 

Excess debt can be fatal: Debt is a low-cost asset. Companies raise money at a fixed rate in the hope that the returns they earn will far exceed the interest they have to pay on their loans. There is nothing wrong with this. The entire financial industry exists on this premise.

The problem begins when companies, and their ambitious promoters, wish to grow overnight. Many of them get swayed by their success at a smaller scale and simply make linear projections into the future on a much grander scale.
 

The result of excessive leverage is that they are left with very little margin for error. Black swan events, like the Coronavirus pandemic and the consequent stopping of activities, make their calculations go haywire. If sales plummet, how will interest be paid? And when interest is not paid, lenders will lay claims on the assets of the company to recover their money. Once assets are sold, future revenue gets jeopardised. Forget growth, even survival becomes impossible in such cases.
 

Companies with high debt also tend to inflate their asset size to justify the extra borrowing. So, when the assets are brought to the market for selling, they do not fetch the price stated in the books. The stock price once again dives as more questions are raised regarding the pricing of all assets. And furthermore, if asset valuation is inflated, then questions arise regarding where the money has actually gone. This, in turn, leads to issues of siphoning and money laundering, which is even worse. An over-ambitious entrepreneur can be forgiven by investors, but a criminal — never.
 

All these and more problems arise due to one reason only — high debt. So, it is best to avoid such companies. More than 7,000 companies are listed on the Indian bourses. Then why bet on those that are minefields waiting to explode?

Pitfalls of excess debt

• Promoters prefer to take debt because lenders don't dictate to them how they should spend the money
• They don't have to dilute their stake in their company
• Regular repayment means they have less money for operational purposes and to fund growth
• Such companies also get into trouble if they use short- or medium-term loans to fund projects that will generate cash only in the long term
• Over-leveraged companies also find it more difficult to raise more debt or equity capital

A stock is a share in a business: The answer lies in how small investors view the markets. Many of them perceive the stock markets as a get-rich-quick avenue. This is a mistake that sober and informed investors in the markets do not make. Investing tests the investor’s patience and commitment. Veteran investor Ramesh Damani aptly calls it the Cathedral of Capitalism.

Instead of going with hare-like promoters who have loaded up on debt to fuel growth, go with the slow and steady turtles who are more likely to build wealth over the long term.
 

The market crash of March 2020 has brought share prices of many companies down from their giddy highs. Some diamonds are today available at the price of coal, while some diamonds still command diamond-like valuations.

What is important is to have diamonds and not coal in your portfolio. The crash offers a once-in-decade opportunity to bolster the quality of your portfolio.
 

To reiterate, look out for companies that have only a small or zero amount of debt on their books. This is a sound precautionary measure that all retail investors should adopt.
 

The writer is a sector expert with the Department of Economic Affairs-National Institute of Financial Management Research Programme