The Importance Of Emphasizing Quality And Financial Health In Your Stock Holdings

According to a recent Bank of America Merrill Lynch survey, a majority of stock fund managers want corporations to improve their financial health as opposed to rewarding shareholders through buybacks and dividends. That has not happened since the earliest stages of the economic recovery.

Why are asset managers, myself included, expressing concern about what companies do with their money? They’ve taken on too much debt. They are leveraged to the hilt. In fact, corporations owe more interest on their debt than at any prior point in history.

That’s not a problem, you argue. The only thing that matters for “credit-worthy” businesses is their ability to service their obligations. And the Federal Reserve will remain very accommodating for many years to come.

Unfortunately, the ability for corporations to service existing debt (a.k.a. “interest coverage”) is at its lowest point since 2009. Imagine that. In spite of a Fed that has kept overnight lending rates near zero for seven years, companies face the same challenge with debt servicing today as they had back in the recession. Worse yet, what is the probable outcome for corporations if Janet Yellen and her Fed colleagues actually hike borrowing costs in the near future?

Perhaps you are skeptical about the notion that public corporations might stumble with respect to growing their businesses while paying back existing debts. Then you might want to look at the changing landscape for companies that reward shareholders with stock buybacks.

At the start of the current recovery up through the end of last year (12/31/2014), PowerShares Buyback Achievers (PKW) outperformed the S&P 500 SPDR Trust (SPY) by a landslide (i.e., 187% to 125%). Since the start of 2015, however, companies borrowing to buy back their stock shares have lost significant momentum. The declining PKW:SPY price ratio below demonstrates the shift from confidence to concern.

Why should corporations that are limiting stock supply and increasing demand through their buybacks see their shares underperform? In essence, there’s trepidation that some corporations have borrowed beyond sensible leverage ratios and simultaneously puffed up their earnings in ways that may not reflect organic growth.