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The Importance Of Quality and Financial Health In Your Stocks

According to a recent Bank of America (BAC) 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), PowerShare Buyback Achievers Fund (PKW) outperformed the S&P 500 (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.

PKW Versus SPY


PKW SPY Price Ratio

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.

Keep in mind, business loans as a percentage of GDP are higher now than at August of 2000 and at August of 2007. The use of leverage by households, government, financial companies and non-financial companies was certainly out of control at those moments in history.

What’s more, the leverage extremes of the past led to credit cycle and business cycle contractions. It follows that it may be reasonable to assume that credit contraction is likely to occur soon enough.

In fact, extremes in the use of leverage tend to downshift at the least opportune times. Fewer borrowed dollars would mean less money for productive purposes (e.g., plants, equipment, human resources, research, etc.) or for immediate investor benefit (e.g., share buybacks, dividend increases, etc.).

Some may believe that central bankers are more prepared for a severe pullback in credit today. Perhaps they would turn toward an even larger open-ended quantitative easing (QE) program or implement a policy of negative interest rates.

The only problem is, corporate bond issuers are already seeing diminishing benefits of lower yields. The Fed, the Bank of Japan, The European Central Bank may be eager to promote lending at a time when they see a need for more stimulus, but it may not matter if households and corporations are fearful of additional borrowing.

It should come as no surprise, then, that companies with the highest-rated financial health have outperformed the S&P 500 in 2015. Whereas buyback “achieving” corporations have been sliding via the PKW:SPY price ratio above, the iShares MSCI USA Quality Factor ETF (QUAL):SPY price ratio has been rising throughout the year.

QUAL SPY Price Ratio


Binge borrowing by corporations may not be a death knell for the bull market in stocks.

Nevertheless, when one factors earnings declines and revenue declines into diminishing benefits from ultra-low borrowing costs, one may find it less lucrative to buy every dip.

You can listen to the ETF Expert Radio Show “LIVE”, via podcast or on your iPod. You can follow me on Twitter @ETFexpert.

Disclosure Statement: ETF Expert is a web log (”blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at he ETF Expert website. ETF Expert content is created independently of any advertising relationship

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