On the sell side, gurus reduced positions in Alcoa Inc. (AA, Financial) and Netflix Inc. (NFLX, Financial), two companies that have high debt burden. As these companies have declining financial strength, these companies have downside potential and possible bankruptcy risk.
Debt ratios measure the financial strength of companies
Among the financial metrics that measure the financial strength of a company, three ratios consider the company’s long-term debt. One of these ratios, the cash-to-debt ratio, directly measures the company’s debt burden: if the C/D ratio is less than one, the company cannot pay off its debt using its cash on hand. Companies that have a severe debt burden not only have a C/D ratio less than one, but also have interest coverage less than 5. Ben Graham, known as the “father of value investing,” eliminates such companies from his consideration.
The distribution of average cash-to-debt ratios across industries is moderately right-skewed, with a median of about 0.6. Based on distribution analysis, about 52% of companies have trouble paying off their debt with cash on hand. About 40 companies have interest coverage lower than Ben Graham’s threshold of 5.
While it does not directly consider the company’s debt, the equity-to-asset ratio measures the company’s leverage, i.e., the amount of debt employed by the company’s operations. As companies issue new debt, their equity-to-asset ratio decreases. Although companies can increase their returns on equity by issuing new debt, the companies are also subject to higher bankruptcy risk if they cannot pay off their debt.
Unlike the distributions of average cash-to-debt ratios and average interest coverage, the distribution of equity-to-asset ratios is roughly symmetric with a median near 0.45.
High debt burden leads to decreasing financial strength
In previous articles, we determined the best industries to invest in using a metric known as the investing score. For this statistical study, we will target the industries to avoid by introducing a score called the “sell potential score.” Based on the following guidelines, we can assign the following scores:
- If an industry’s average equity-to-asset ratio is greater than its average historical median equity-to-asset ratio, we assign a 1. Otherwise, we assign a 0.
- An industry scores 1 if its current cash-to-debt ratio underperforms its average historical median cash-to-debt ratio. It scores an extra point if the cash-to-debt ratio is less than one.
- An industry scores 1 if its current interest coverage underperforms its average historical median interest coverage and a further point if the current interest coverage is less than five.
We repeat this process for the median debt ratios and add up all the scores to find the sell potential score. Forty-three of the industries have a sell potential score of at least 8. A few industries, including copper and aluminum, have the highest sell potential score of 10.
Alcoa, an aluminum manufacturing company, currently has a weak profitability rank of 3. The company has negative net margins, returns on equity and three-year revenue growth. Additionally, the company’s per-share revenue has declined during the past five years.
Although it has a financial strength rank of 5, Alcoa has a poor financial outlook. The company has weak financial strength scores, and is burdened with debt based on its near-zero interest coverage. During the past 10 years, the aluminum engineering company had volatile Piotroski F-scores, and its Altman Z-score generally languished in distress zones.
Although it has a strong Z-score, Netflix also has a financial strength rank of 5. The internet TV company has a slightly weaker F-score than Alcoa does, and its Beneish M-score suggests earnings manipulation. Additionally, Netflix’s interest coverage and equity-to-asset ratio underperforms 77% and 79% of global pay TV companies, respectively.
Richard Snow (Trades, Portfolio) eliminated his Alcoa position during the second quarter, selling all 102,530 shares at an average price of $9.74. Manning & Napier Advisors Inc. trimmed its stake in Alcoa during the past three quarters, including 2.5 million shares during the most recent quarter.
Three gurus have eliminated their Netflix position: Chase Coleman (Trades, Portfolio), Julian Robertson (Trades, Portfolio) and George Soros (Trades, Portfolio). After purchasing over 10 million Netflix shares during the second quarter of 2015, Coleman sold his near 18 million share stake in the company at an average price of $96.07 per share. With this transaction, the guru wiped out 26.53% of his portfolio.
Robertson pared 6.17% of his portfolio after exiting his Netflix position.
See also
Short seller James Montier developed a value screener that lists “ideal short candidates,” companies that make good sell targets. Such companies have a Piotroski F-score less than 3, a five-year average asset growth greater than 10, and a price-to-sales ratio higher than 90% of companies in its industry.
Alternatively, the “Distressed Companies Screener” lists the companies that have the following characteristics:
- The company’s Piotroski F-score is less than 3.
- The company’s cash-to-debt ratio is less than 1, and its interest coverage is less than 5.
- The company’s equity-to-asset ratio is less than 0.4.
As of Sept. 27, the screener listed 52 companies. A backtesting of this strategy shows that these companies generally underperform the market. The test portfolio returned a meager 5% overall with yearly rebalancing and up to 50 stocks ranked by increasing F-scores.
You can view the consensus sells in several ways, including most active sells, and screen for consensus sells.
Disclosure: The author has no position in any stock discussed in this article.
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