Anatomy of the Bear Market- Leverage

Published On: 17-Aug-2020

The outbreak of COVID-19 is being referred to as a “once in a century event” and has heightened uncertainty for many companies which have to deal with the prospect of a significant drop in their cash flows. The longer the pandemic persists, greater the risks as leveraged businesses might find it hard to service the debt or access credit. In our last blog, we had analyzed how companies had performed during this pandemic – first during the panic in the markets and then during the subsequent recovery. The analysis was based on the twin pillars of our research methodology – Return on Capital employed (RoCE) and Operating Cash Flow (OCF). Here in this blog, we have extended our focus to debt and leverage ratios of the companies.

If we had to analyze the volatility in price performance of the stocks post Feb-2020, it’s a tale of two different halves. In the data placed below, we have analyzed the performance of companies in S&P BSE 200 index (for non-financial companies) in Mar-2020 (period of fall) and from Apr-2020 to Jul-2020 (recovery phase). Companies have been sorted based on two metrics. The first metric - Net Debt to Equity explains the extent of a company’s indebtedness.  The second metric is Net Debt to EBITDA which is a measure of company’s ability to service debt.

Chart 1  Data source: Bloomberg. Average Returns of stocks in S&P BSE 200 are in absolute (point-to-point). Above data based on financials as of FY19 Non-financials (no. of companies) – 154; Break-up of Net Debt to Equity Tiers (no. of companies): <0 – 72, 0 to 0.5 – 38, 0.5 to 1 – 24 and >1 – 20

Data source: Bloomberg. Average Returns of stocks in S&P BSE 200 are in absolute (point-to-point). Above data based on financials as of FY19 Non-financials (no. of companies) – 154; Break-up of Net Debt to Equity Tiers (no. of companies): <0 – 72, 0 to 1 – 26, 1 to 3 – 26 and >3 – 30 EBITDA – Earnings before Interest, Taxes, Depreciation & Amortisation

The above data suggests that companies with higher leverage (Net Debt to Equity of 0.5 to 1 and Net Debt to EBITDA of >3) have fallen more in Mar-2020 when compared to low leveraged companies. However, in recovery phase, which is from Apr-2020 to Jul-2020, they have fared better.

In the charts below, we look at the performance of companies over a 1-year time frame, but for two different periods. The 1-year period as of Feb 29, 2020 - before the COVID-19 induced panic and the 1-year period as of July 31, 2020 - which includes the recent recovery in the market. The data indicates that leveraged companies have continued to underperform and in fact this underperformance has widened further. In other words, despite the outperformance of the leveraged companies post Mar-2020, they are still underperforming over a longer time period.

Chart 2 Data source: Bloomberg. Average Returns of stocks in S&P BSE 200 are in absolute (point-to-point). Above data based on financials as of FY19 Non-financials (no. of companies) – 154; Break-up of Net Debt to Equity Tiers (no. of companies): <0 – 72, 0 to 0.5 – 38, 0.5 to 1 – 24 and >1 – 20

Data source: Bloomberg. Average Returns of stocks in S&P BSE 200 are in absolute (point-to-point). Above data based on financials as of FY19 Non-financials (no. of companies) – 154; Break-up of Net Debt to Equity Tiers (no. of companies): <0 – 72, 0 to 1 – 26, 1 to 3 – 26 and >3 – 30 EBITDA – Earnings before Interest, Taxes, Depreciation & Amortisation

In the first chart (Net Debt to Equity), the difference between the 1-year average return based on Net Debt to Equity Tiers of highly leveraged companies (>1) and no leverage companies (<0) was nearly 10% as of Feb-2020. Moving forward to July-20 and despite the recent recovery, this divergence between the highly leveraged companies and no leverage companies has further increased to 17%. Similarly, in the second chart (Net Debt to EBITDA), 1-year average return differential of companies with Net Debt to EBITDA of >3 and companies with Net Debt to EBITDA of <0, has increased from 7% as of Feb-2020 to 16% as of Jul-2020. Over the entire cycle the companies with less leverage have done better than the more heavily leveraged companies on average.

We also analyzed the performance of all constituents (including financial companies) of S&P BSE 200 index. Financial sector companies have been further divided into lending & non-lending businesses (includes Insurance, Asset management, Brokerages, Exchanges etc). The reason for this break-up is that by definition, lending businesses involve leverage, whereas non-lending businesses may or may not use leverage. We observed that, companies in lending business have significantly underperformed not just during the fall i.e., in Mar-2020 but also during the subsequent recovery period.

Performance of stocks (average returns) based on Industry Classification

Chart 3 Data source: Bloomberg. Average Returns of stocks in S&P BSE 200 are in absolute (point-to-point). Above data based on financials as of FY19 Break-up based on Industry Classification (no. of companies): Non-financials – 154, Financials (Non-lending) – 12 and Financials (Lending) – 33

From the above data, the average fall was ~40% for Financials (Lending) in the month of Mar-2020 and even in the recovery phase, they underperformed the rest of the pack. Because of underperformance in the recovery phase, its impact is also seen in 1-year performance. Financials (lending) has also underperformed non-financial companies by over 35% as of Jul-2020 on 1-year performance. This is quite logical as the shutdown and reduced levels of activity in the economy will affect the ability of borrowers to repay the lenders. Furthermore, we also know that this sector is leading the race to raise fresh capital to deal with the specter of rising non-performing loans.

We have argued in the past that it is impossible to predict, but that it is possible to be prepared. A focus on RoCE and OCF when combined with debt metrics leads to selection of companies that can navigate unexpected challenges like in the current pandemic. As always, there are exceptions to the rule. Peruse the analysis below of the Top 10 contributors to the S&P BSE 200 index over the past 1-year and the exception stick out rather obviously.

Top 10 contributors to S&P BSE 200 performance in last 1 year (as of Jul 31, 2020)

Chart 4
In the above table, all the companies except for two are net cash or have close to “zero” debt and are also R1 and C1 rated companies based on RoCE and OCF tiers. The two exceptions:

  • Reliance Industries has Debt to Equity of 0.72x and Debt to EBITDA of 3.3x. The company has a RoCE rating of R2 and an OCF rating of C1

  • Bharti Airtel has Debt to Equity of 1.5x and Debt to EBITDA 4.3x. The company has a RoCE rating of R3 and an OCF rating of C1

Of course, both companies have aggressively de-leveraged by raising capital in recent times and are likely beneficiaries of consolidation in the Telecom Industry. And the market may be excited by their future growth prospects.

There lies the twist in the tale. The odds of going wrong are much lower with companies having consistency of earning high RoCE, positive OCF and low or no debt. They can navigate the unexpected rather well. However, investing in companies having weaker RoCE and carrying leverage could be rewarding, if such companies manage to sail through the cycle successfully. The reward here is potentially higher returns. But, arguably lower probability of getting it right because both the company specific factors and exogenous factors need to play out in one’s favour.

Going back to the issue of pandemic proof investing. The first thing to remember is that the future cannot be predicted. But, you can be prepared. The next crisis may be something different. Our ranking system for companies based on the twin pillars of RoCE and OCF are our best tool to judge the ability of companies to navigate a challenging period that we cannot predict. Leverage also makes a material difference as we have just seen. How we choose to allocate across these buckets, plays a role in the volatility experienced by the portfolios when a crisis strikes. And there are always exceptions to every rule.

Disclaimer

Disclaimer for Market Review/Research Report

Author Bio

Sachin Trivedi
Mr. Sachin Trivedi is Senior Vice President and designated as Head of Research &amp; Fund Manager, Equity at UTI AMC Ltd. He is a B.com graduate from Narsee Monjee College of Commerce, Mumbai and holds a post-graduate degree in management (MMS) from the K. J. Somaiya Institute of Management Studies &amp; Research, Mumbai University. He also holds a CFA charter since 2004 conferred on him by the CFA Institute, USA. He began his career in June 2001, with UTI. Sachin has 16 years experience in research and portfolio management. In research he has specialized in Auto OEM, Utilities, Capital Goods and Logistics.