Does corporate debt impact stock returns?

‘He who is quick to borrow, is slow to pay.’

This quote seems apt not only for individuals but also for companies. Generally speaking, market participants tend to stay away from companies which have huge amounts of debt on their books. Again, pretty similar to a real-life scenario, where you would want to avoid a friend who has piled huge debt onto himself. 

The question you must ask yourself is – ‘Is debt really bad for business or is it made to look so?’ Well, the answer is a bit of both. Debt taken in the right proportion, to your overall business, size is actually good as it relatively brings down the overall costs. However, if the debt amount is unfeasible with respect to the size of the company, it could turn out to be a slippery slope.

Well, in order to logically pursue this issue, we crunched a few data items to quantify debt’s effect on businesses. Before we jump to the findings of the study, let me introduce a concept – leverage. Leverage is essentially a concept using which you can get to the target without completely using your own resources. For instance, a car loan. Let’s assume I buy ₹2 crores worth of car for which I take a loan of ₹1.5 crores and the remainder ₹50 lakhs I pay on my own. What am I doing here? I am using leverage of ₹1.5 crores to buy something worth ₹2 crores.

Similarly, businesses take leverage (debt/loan) in order to carry out their business plans. For example, if Tata Motors has to set up a manufacturing plant in the country, it requires huge capital. Therefore, it will take a loan or in other words use leverage. Goes without saying that the reduction of debt/loan is known as deleveraging. 

Now, let us get to the study we undertook i.e. to check the positive effects of deleveraging, if any, on companies over the last 10 years (2013-2023). The interesting aspect about debt is people dislike companies taking on debt, but like twice more when these companies pay back their loans on time. So let us see if deleveraging results in superior price returns for stocks listed in India.

For the purpose of this study, we have taken the top 1000 companies in India by market capitalization. From this group, we have only taken those companies which have been listed since March 2013. We have excluded companies belonging to 11 sub-industries from the banking & financial services sector for the purpose of this analysis. Since these companies take on debt to lend further, the positive effects of deleveraging do not apply to such companies.  

After all filtrations, we were left with 573 companies. Over the course of the previous 10 financial years, this is the trend of net debt reduction of companies. 

269 companies had reduced their net debt in FY2014, 305 in FY2015 and so on. Net debt refers to total debt minus cash and short-term investments.

Now let us evaluate their performance. Attached below is the comparison between the median price performance of companies whose net debt increased or remained the same (non-deleveraged) versus companies whose net debt reduced (deleveraged). Please bear in mind that if a company is reducing its debt in FY20 we are expecting their price returns to show superior performance in the next fiscal, which is FY21. In reference to this chart, the price performance shown for FY15 relates to companies that reduced their debt levels in FY14.  

It is clear that in the majority of cases, deleveraged companies have done better than non-deleveraged ones, especially during bearish market environments. This is perhaps because there is a change in sentiments towards a stock that has off-loaded debt from its books. Deleverage firms often perform better due to reduced financial risk and increased operational flexibility. With less debt, these firms have lower interest payments and more cash flow to invest in growth opportunities. This can lead to better profitability and the ability to weather economic downturns.

One can also look from a quality factor point of view. As we all know that in factor investing, the quality factor has been recognized as one of the major drivers of stock returns. Quality works well in bearish or sideways markets. One of the most important parameters which index houses across the world use to calculate the quality score of companies is debt (as a %) of a company. Needless to say that the above analysis clearly selects companies which have improved on their debt structure and have increased their quality ranking as compared to their peers. As studies have documented that during a bull phase, quality as a factor generally underperforms other factors like momentum. This is visible in the above chart also that post COVID i.e. FY20, there is not much difference in the returns of deleveraged vs non-deleveraged firms, when markets across the globe and India were in full upswing. Hence this leverage versus non leverage debate might not be worth considering during bullish markets, but definitely worth considering during bearish or sideways market sentiments scenarios.

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