The topic, by itself, is a magnet for controversy. Most disciples of Graham and Buffett will not touch highly geared stocks with a 10-foot pole. For me, there is always this grey area where highly geared stocks with other redeeming factors lie, and I am always concerned about throwing the baby out with the bathwater.
My criteria for considering highly geared stocks includes the following:
Low Operating Leverage
Leverage comes in pairs: financial leverage and operating leverage. All things being equal, a company with low operating leverage has a greater capacity to take on debt than a company with high leverage. A company with a low proportion of fixed costs to variable costs is deemed to have low operating leverage. For example, a company with zero operating leverage (all its costs varying with sales) will see its costs fall in line with a decline in sales. This will help to buffer the hit to the net profit from any sharp decrease in revenue.
Non-Recourse Debt
Non-recourse debt refers to debt collateralized by a specific asset. In a default scenario, the lender can seize the asset to pay off the debt, but the company has no further obligations to the lender beyond the collateralized asset. This is the case with many real estate operating companies and property developers, where non-recourse debt is used to finance their projects.
Consumer Non-Discretionary Stocks with a Long Track Record of Profitability
In a downturn, people will cut down on luxury or discretionary spending and consumer discretionary stocks will see profits drop or even turn into losses. On the other land, consumer non-discretionary stocks are more likely to continue generating positive cash flow and net income to service interest payments.
My criteria for considering highly geared stocks includes the following:
Low Operating Leverage
Leverage comes in pairs: financial leverage and operating leverage. All things being equal, a company with low operating leverage has a greater capacity to take on debt than a company with high leverage. A company with a low proportion of fixed costs to variable costs is deemed to have low operating leverage. For example, a company with zero operating leverage (all its costs varying with sales) will see its costs fall in line with a decline in sales. This will help to buffer the hit to the net profit from any sharp decrease in revenue.
Non-Recourse Debt
Non-recourse debt refers to debt collateralized by a specific asset. In a default scenario, the lender can seize the asset to pay off the debt, but the company has no further obligations to the lender beyond the collateralized asset. This is the case with many real estate operating companies and property developers, where non-recourse debt is used to finance their projects.
Consumer Non-Discretionary Stocks with a Long Track Record of Profitability
In a downturn, people will cut down on luxury or discretionary spending and consumer discretionary stocks will see profits drop or even turn into losses. On the other land, consumer non-discretionary stocks are more likely to continue generating positive cash flow and net income to service interest payments.
