Do Debt Levels Predict Stock Prices?

Since the stock market tumble in the fourth quarter of 2008, stocks have experienced extreme volatility and investors have felt very uncertain about returns. As such, many investors have become risk adverse and unwilling to invest in companies with weak balance sheets. But are investors right to avoid stocks with high debt? Do stocks trade based on the strength of a balance sheet?

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Stock Price is a Function of Debt Levels
Late 2008 through 2009 was an unprecedented period in the stock market. But there were clearly some stocks that were harder hit than others. Was the impact on stock prices due to the strength of the balance sheet?

Trico Marine Services (NYSE:TRMA) provides subsea and marine support vessels and services to oil and natural gas exploration and production companies. In 2008 the company made a very large purchase with debt. As the price of oil fell from roughly $150 to $50 a barrel, the company got caught with very high debt and significantly reduced revenues. From 2007 to 2008, long-term debt increased from $157 million to $724 million while operating profits decreased from $66,630,000 to -$127,545,000. As of December 2009, TRMA's debt was 88.1% of its capitalization. In its latest 10K the company states:

We have a significant amount of debt and our business is highly cyclical in nature due to our dependency on the levels of offshore oil and gas drilling and subsea construction activity. Our forecasted cash and available credit capacity are not expected to be sufficient to meet our commitments as they come due over the next twelve months and remain in compliance with our debt covenants.

As a result of the market activity, the company's stock fell from $36 in June 2008 to about $5 in January 2009. Currently the stock resides at $3, 8% of its high.

McGrath RentCorp (Nasdaq:MGRC) is a diversified rental company. MGRC has total debt of $247.33 million and a levered free cash flow of $41.22 million. The company just recently took on this debt to finance an acquisition as it took advantage of the weak markets to buy a seemingly good asset. The stock experienced very little volatility as compared to the market with a high of $28 in Sept 2008 to a low of $15 in February 2009, and currently sits at about $25. Based on these two examples, it appears that stock price is a function of debt levels and balance sheet strength. However, the following examples may disprove this. (For more, see Will Corporate Debt Drag Your Stock Down?)

Stock Prices are Not a Function of Debt Levels
Garmin (Nasdaq:GRMN) designs, develops, manufactures and markets global positioning system or GPS-enabled products and other navigation, communication and information products worldwide. The company has no debt and a levered free cash flow of over $700 million. Despite this strong balance sheet, the stock has been extremely volatile, moving from a high of $111 in Sept 2007 to a low of $17 in Nov 2008, and a current price of $37, 33% of its high.

Freeport McMoRan (NYSE:FCX) engages in the exploration, mining and production of mineral resources. The company currently has total debt of $6.35 billion and a levered free cash flow of $2.79 billion. The company took on this high debt when they purchased Phelps Dodge in early 2007. Despite the high level of debt, the company's stock still soared to high levels. The price has been extremely volatile shifting from $115 in June 2008 to a low of $25 in January 2009 to a current price of $80 while the level of debt has been declining. These two stocks provide evidence that something other than debt level is the influencing factor on stock prices.

The Bottom Line

The strength of a balance sheet, while important, does not seem to be the sole factor that influences the price of stocks. However, in circumstances when the level of debt is overwhelming and the company is unable to pay its current obligations, then debt is a formidable force on the stock price. Investors need to be aware of the balance sheet and consider it with other factors when making investment decisions. (For more, see 4 Steps To Building A Profitable Portfolio)

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