Corporate debt has soared to record levels, and investment professionals are worried. Interest rates have risen since much of this debt was incurred, so refinancing will increase interest expense, reducing profit margins and cash flow. As the economy decelerates, perhaps heading into recession, corporate revenue growth will slow, raising debt service burdens for leveraged firms.
Goldman Sachs had recommended stocks with strong balance sheets (low debt). They now prefer companies that are reducing debt aggressively, including these 12: Tapestry Inc. (TPR), Newell Brands Inc. (NWL), Dollar Tree Inc. (DLTR), Hormel Foods Corp. (HRL), ConocoPhillips (COP), Abbott Laboratories (ABT), Pentair PLC (PNR), Quorvo Inc. (QRVO), Maxim Integrated Products Inc. (MXIM), Micron Technology Inc. (MU), Gartner Inc. (IT), and NRG Energy Inc. (NRG). See table below.
12 Stocks on Debt Diets
(Change in Debt Outstanding Over Last 12 Months)
- Tapestry -40%,
- Newell Brands -34%
- Dollar Tree -25%
- Hormel Foods -29%
- ConocoPhillips -24%
- Abbott Labs -30%
- Pentair -45%
- Quorvo -34%
- Maxim Integrated -33%
- Micron -33%
- Gartner -30%
- NRG Energy -31%
Source: Goldman Sachs
Significance for Investors
"The longevity of the current economic cycle and historically elevated net leverage means after evaluating investment opportunities corporate managers with excess cash may decide to delever [i.e., reduce debt]," Goldman writes in a recent edition of their U.S. Weekly Kickstart report. They believe that many companies will pivot from share repurchases to debt reduction.
Indeed, major corporations are making debt reduction a top priority in response to investors' concerns, Bloomberg reports. Stephanie Pomboy, founder of economic consulting firm MacroMavens, is among those who believe that corporate debt is dangerously high, per a lengthy interview with Barron's.
Goldman's basket of 50 strong balance sheet (low debt) stocks has outperformed 50 weak balance sheet (high debt) stocks by 30 percentage points "since the Fed began its steady pace of interest rate hikes at the end of 2016." However, they no longer favor this strategy for three reasons: the dovish turn by the Fed; a growing likelihood, in Goldman's opinion, that global economic growth may stabilize; and increased valuations for strong balance sheet stocks.
Instead, Goldman now prefers stocks that are reducing debt by the largest percentages, rather than those that already have low debt levels. Among S&P 500 companies, the report says, "Firms prudently reducing leverage have modestly outperformed those adding new debt since 3Q 2018 as the pace of growth has slowed."
The median stock in Goldman's basket of the 50 biggest debt reducers on a percentage basis delivered a 12-month return of 7% through March 21, 2019, the same as the median S&P 500 stock. Meanwhile, the median stock among the 50 biggest debt increasers produced a 3% return. Both baskets exclude financial stocks and stocks with net debt to enterprise value (EV) ratios in the lowest 20% of the S&P 500 as of March 21. This eliminates the lowest-leveraged stocks.
No screening process can deliver guaranteed results. Tapestry and Newell suffered negative returns of 38% each over the last 12 months. Tapestry owns the Coach and Kate Spade apparel and accessories brands. Newell is a wide-ranging consumer goods conglomerate, some of its brands being Calphalon, Mr, Coffee, Oster, Rubbermaid, Sunbeam, Coleman, Parker, Expo, Paper Mate, Sharpie, Waterman, Elmer's, Marmot, and Yankee Candle.
Newell's CEO is being forced out by weak sales and missed targets, per The Wall Street Journal. Meanwhile, a rising market for resales of used apparel and accessories may be hurting fashion companies like Tapestry, per Yahoo Finance.