To print article, click
Print on your browser's File menu.
Go back
Go back
Posted 11/29/2001
Details
 |
Related Resources
Check out our new StockScouter rating system
Find the top-rated stocks
What are the top-rated funds?
Screen for the stocks you want to own
Check out basic and deluxe searches for stocks
Track your investments on MSN Money
Read the latest market dispatches
Check out the latest in the markets
Who’s next on CNBC
Recent Articles
• As you feast, give thanks for speculators, 11/21/01
• You make money by breaking the rules , 11/15/01
• Beware the day after a comeback, 11/8/01
more...
|
The Speculator
In 2001, debt doesn't seem to matter
S&P 500 companies with significant debt this year are outperforming their debt-free counterparts, for reasons perhaps only our Atomic Theory of Markets can fathom.
By Victor Niederhoffer and Laurel Kenner
Nature's rules apply for all particles and interactions.
-- Gordon Kane, "Supersymmetry: Unveiling the Fundamental Laws of Nature"
| New
stock picks from market professionals every day on CNBC. |
Always in search of an edge -- whether from Beethoven symphonies, the periodic table or forest ecology -- we've been looking lately at new conceptual frameworks that physics might hold for investors. We're still in the early stages of developing our Atomic Theory of Markets, but what we've found so far emboldens us to share a model inspired by one aspect of it.
We'll say at the outset, however, that we're not buying stocks right now. The implied volatility of at-the-money index options on the Chicago Board Options Exchange has once again dropped below 25%, low enough to make us bearish. We advise readers who bought our biotech portfolio to sell it over the next four days, or hedge by short-selling Biotech HOLDRs (BBH, news, msgs). With the market signals flashing red, what we'll present in this column is something for the inevitable rainy day, rather than immediate guidance.
The debt dilemma
What's troubling us at the moment is the question of debt. Fantastic quantities of leverage have proved the undoing of the once-mighty energy trading company Enron (ENE, news, msgs). And the conventional wisdom says that to survive an economic downturn such as the one we're currently experiencing, a company must have little or no debt.
Thus it's puzzling that this year, as a rule, companies with high debt loads have distinctly outperformed their low-debt counterparts. So far in 2001, the 50 companies in the S&P 500 with the highest debt-to-equity ratios have fallen 6% as a group, while the companies with the 50 lowest debt-equity ratios have fallen 24%. (Click here for the first group; here for the second.)
Debt is good in 2001 …
S&P 500 companies with the highest and lowest debt-to-equity ratios, ranked by 2001 stock performance.
| Big debtors* | Debt/Eq. Ratio | % Price Chg '01 |
| Xerox (XRX, news, msgs) | 4.35 | 78.2 |
| Cendant (CD, news, msgs) | 2.58 | 69.9 |
| Ball (BLL, news, msgs) | 2.04 | 48.9 |
| Equifax (EFX, news, msgs) | 2.71 | 47.1 |
| Freeport-McMoRan Copper (FCX, news, msgs) | 17.95 | 44.2 |
| Sprint PCS (PCS, news, msgs) | 10.15 | 32.3 |
| Sears , Roebuck (S, news, msgs) | 3.09 | 30.2 |
| USA Education (SLM, news, msgs) | 12.98 | 28.5 |
| International Game Tech (IGT, news, msgs) | 3.06 | 27.2 |
| Harrah's (HET, news, msgs) | 2.85 | 25.1 |
| Low debtors** | ||
| Compuware (CPWR, news, msgs) | 0.00 | 67.0 |
| National Semi (NSM, news, msgs) | 0.01 | 56.7 |
| KLA-Tencor (KLAC, news, msgs) | 0.00 | 54.9 |
| Circuit City (CC, news, msgs) | 0.01 | 49.9 |
| Bed Bath & Beyond (BBBY, news, msgs) | 0.00 | 47.8 |
| Microsoft (MSFT, news, msgs) | 0.00 | 46.9 |
| Autodesk (ADSK, news, msgs)_ | 0.00 | 36.2 |
| American Power (APCC, news, msgs) | 0.00 | 14.3 |
| Novellus Systems (NVLS, news, msgs) | 0.00 | 13.1 |
| Maxim Integrated (MXIM, news, msgs) | 0.00 | 13.0 |
**Debt/equity ratio .01 or lower
Is this always true? Our research suggests it's not. And here's where we take a detour into physics.
Begin with the widely accepted idea that everything around us is made of atoms. The atom itself is made up of protons, neutrons and electrons, organized into a fashion similar to the solar system. The protons and neutrons are in the nucleus. Electrons circle around the nucleus, held in place by the oppositely charged protons, but often ready to go off and interact with particles on the outside.
In the marketplace, the atoms are corporations. The nucleus is composed of debt and stockholders' equity. The revolving electrons are the assets, be they patents, raw materials, machinery, inventory, cash or land. Like electrons, the assets often interact with things on the outside -- such as customers, specifically, or if you think bigger, socioeconomic trends.
We hypothesized that companies without big debt loads would be have "lighter" nuclei. Their stock prices would thus be more affected by the overall market than the stock prices of debt-laden companies. This is contrary to the usual theory that debt-free companies are much less affected by outside market forces than companies carrying large amounts of debt.
To study this idea, we considered every S&P 500 company that had no long-term debt or short-term borrowings on its balance sheet, starting in 1996, up to the present. To round out our sample to some 20 companies a year, we also included a few businesses with 1% or less total debt to equity. We considered only companies that actually were in the S&P 500 at the beginning of each of the years under study. (As we often have said, and cannot emphasize too strongly, retrospective bias often mars investment studies.)
We compared the performance of these companies to a control group of companies that all had debt of at least 1.4 times the value of their equity. Altogether, this gave us some 300 company-years of data.
The results support our hypothesis. On balance, the companies with no debt (or hardly any) rose an average of 19% a year during the study period, versus -2% for the companies with high debt.
Some of these debt-free and debt-saddled companies showed extraordinary changes. For example, in 1996, a year when the S&P 500 rose 20%, Cisco Systems (CSCO, news, msgs), a company with no long-term debt, went up 70%. Similarly, Gateway (GTW, news, msgs), with no short-term or long-term debt, rose 182% in 1999, while the S&P 500 rose 20%. On the other side, Temple Inland (TIN, news, msgs), with long-term debt equal to some five times the market value of its equity, fell 3% in 1997 while the S&P 500 rose 31%.
As a practical matter, buying debt-free companies would have paid well, on average, over the past six years. But keep in mind that the cycles are always changing, and that new particles or forces that we have not yet uncovered may be influencing the results. Our system is therefore at best a high-percentage play, not a magic elixir.
After all, consider the results this year, when, as noted, the high-debt stocks were actually the most successful -- probably because they were also considered "value" plays during a time when growth companies are being shunned. Year to date in 2001, with the S&P down 12%, debt-free Cisco is down 48%
Other atomic rules
The atomic model is just one of the laws of physics that we think has applicability for the market. We're also looking at a law known as "conservation of charge," which holds that if an excess negative charge exists, the excess charge particles, or electrons, must have come from somewhere, and if an excess positive charge exists, then the missing electrons must have gone somewhere. This seems to us quite similar to the idea that in business, an increase in an asset must come from a source, and a decrease in an asset must go to some use.
We're also exploring the market potential of the idea that energy cannot be created or destroyed, although it can change from one form to another. This implies that the astute investor should try to identify energy sources, determine whether they have been stored as potential energy or already are affecting the company, and then try to predict how the next transformations will affect the particular investments under consideration.
We're still in the early stages of exploring these concepts. Many who have seen our preliminary efforts, including physics professors, research directors of physics at very large firms, and other scientists, have told us that these ideas are hopeless and useless, as markets involve human volitions and facts that can never be analogized to the non-living physical forces that are the basis of our model. Others have been kind enough to steer us into ideas based on lasers and electronics that seem to provide close analogous fits.
We would like to hear your views. Write to us at dciocca@bloomberg.net, and we will send you a workout of the kinetic energy volatility system, a table with our results on the performance of debt-free companies and a list of books that we have found particularly helpful in understanding the new developments in physics.
At the time of publication, neither Victor Niederhoffer nor Laurel Kenner owned any of the equities mentioned in this column.
MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.