In part 1 found here, Why Record Corporate Debt Might Not Be So Bad: 8 Debt-Laden Blue Chips – Part 1 of this two-part series, I pointed out that low interest rates have been a strong motivating factor for publicly traded companies to utilize debt over equity to finance their operations. Simply stated, it is a lot cheaper for companies to issue debt than it is to issue equity. This has not only resulted in corporations becoming more highly leveraged than perhaps ever before, it also has destroyed shareholder equity (book value) for many companies. These higher levels of debt and lower levels of shareholder equity (book value) had the additional side effect of collapsing the credit ratings of many publicly traded companies.
As evidence of that last point, in part 1, I reported that only 2 companies – Johnson & Johnson (NYSE: JNJ) and Microsoft (NASDAQ: MSFT) – are AAA rated today compared to 60 companies that held that coveted rating in the early 1990s. Additionally, I also shared a report pointing out that half of all investment grade corporate debt is rated BBB or lower, and one third of those companies rated BBB-, which is only one notch away from junk status.
In this part 2, I want to share an additional perspective that my research on the growing levels of corporate debt uncovered. In 2018 there was an excellent white paper produced by O’Shaughnessy Asset Management titled “Negative Equity, Veiled Value, and the Erosion of Price-to-Book.”
Many of the most debt laden stocks that have negative equity have inexplicably outperformed the market most of the time. Moreover, as I will elaborate on later with a few examples, many of these highly leveraged companies are being awarded what appear to me to be excessive valuations. But perhaps more importantly, they have continued to command these high valuations for, in some cases, several years. The following excerpt from the introduction to the white paper pointed out some facts that have been confusing me for some time:
“O’Shaughnessy Asset Management
Negative Equity, Veiled Value, and the Erosion of Price-to-Book
RESEARCH BY TRAVIS FAIRCHILD, CFA: APRIL 2018
The price-to-book ratio has a problem. More and more U.S. companies report negative book value, the result of accounting rules and structural changes in the market. This creates broad confusion and problems for the famous value factor, and indexes or strategies which rely on it as a measure of cheapness. Negative equity companies are often written off as distressed, but after reporting negative equity, most of them survive for years and have, as a group, outperformed the market 57% of the time.(For the other valuation factors, we use Price to Sales, Price to Earnings, EBITDA to Enterprise Value, Free Cash Flow Yield, and Shareholder Yield.)”