Leverage loved in equities spurs broadest rally since 1995

May 20, 2013 05:32 AM

The most-indebted U.S. companies are rallying more than any time in almost four years compared with the rest of the stock market amid the broadest rally since at least 1995.

Federal Reserve interest rates near zero and the expanding economy are allowing Standard & Poor’s 500 Index companies with the lowest working capital, smallest earnings and highest debt ratios to reduce borrowing costs and avoid default. The stocks surged 27% this year, almost double the gains for businesses with the most cash and least borrowing, according to data compiled by Bloomberg and Goldman Sachs Group Inc.

Bulls say the spread shows the futility of fighting the Fed at a time when more than 90% of the companies in the Russell 1000 Index have risen in 2013, the most in at least 18 years. Bears say loose monetary policy has inflated prices and owners of the riskiest stocks will suffer the biggest losses when the Fed curtails bond purchases.

“The rally is so broad that the weakest companies that hadn’t been participating have finally caught fire and roared ahead,” said Anthony Lawler, a fund manager who helps oversee about $53 billion at GAM Holding AG in London. “A rally can stay broad-based for a period of time. It’s not an indication that it’s toppy.”

Stocks advanced last week, pushing the S&P 500 up 2.1% to 1,667.47 for its fourth consecutive increase. The benchmark gauge for U.S. equities has rallied 17% in 2013 and 146% since rebounding from a 12-year low in March 2009, adding about $11.5 trillion in market value. The S&P 500 slipped 0.1% at 9:59 a.m. in New York today.

Banks, Miners

Industries most reliant on economic growth have led gains since the S&P 500 reached a six-week low on April 18, data compiled by Bloomberg show. Banks, mining companies, technology producers and material shares climbed more than 9% in the period. A total of 914 companies in the Russell 1000 have risen this year, the most since Bloomberg data starts in 1995.

Indebted companies beat those with stronger finances by about 1 percentage point since April 28 after outperforming by 9 points in the first three months of the year, the most since the third quarter of 2009, the data show.

“The catch-up is greater in stocks with weak balance sheets,” Hayes Miller, who helps oversee about $48 billion as the Boston-based head of asset allocation in North America at Baring Asset Management Inc., said in a phone interview on May 17. “Investors by and large feel they have to gain greater exposure to equities.”

Altman Rankings

The baskets ranking S&P 500 companies by balance sheets are drawn by Goldman Sachs using criteria developed by New York University Professor of Finance Edward I. Altman in the 1960s. Altman tried to predict probabilities of corporate default by combining income and financial ratios that include working capital, assets, sales, earnings and equity.

Companies in the weaker-finance group -- from Constellation Brands Inc. to Tenet Healthcare Corp. -- have median debt equaling 0.77 times equity and 2.67 times earnings before interest, taxes, depreciation and amortization, according to Bloomberg data.

Debt is 0.12 times equity and 0.35 times Ebitda for the strong-balance-sheet index, the data show. That group includes companies form Exxon Mobil Corp., the largest U.S. oil company, to Urban Outfitters Inc., a Philadelphia-based retailer.

Fed Options

Companies with more solvency risk are beating the market in part because Fed policy gives them more options for raising money. The central bank has pumped $2.3 trillion of stimulus into the economy and held the benchmark lending rate near zero% for more than four years.

More than 380 speculative-grade borrowers, with credit ratings below Baa3 by Moody’s Investors Service and BBB- at S&P, have raised $158.3 billion through bond sales in the U.S. this year, compared with $130.5 billion by this time in 2012, data compiled by Bloomberg show. Last year’s total of $358.9 billion in junk debt set a record.

Yields on junk bonds dropped to 5.3% from 8.2% in June 2012, according to Barclays Plc indexes. That’s the lowest rate compared with AAA-rated corporate debt since 2007, the data show. Moody’s said May 8 that 12-month default rates among the least creditworthy companies worldwide reached 2.6% in April, down from almost 8% in May 2010.

Debt Refinanced

Shares of S&P 500 companies rated speculative grade by S&P have climbed 24% on average in 2013, compared with 18% for those with investment grades, according to data compiled by Bloomberg. Dallas-based Tenet has jumped 41% as the third-largest for-profit U.S. hospital chain refinanced debt at half the cost it paid to borrow in the past.

“It has become much cheaper for companies with below-grade ratings to borrow, relative to their stronger peers,” said Adrian van Tiggelen, a senior investment specialist at ING Investment Management in The Hague, which oversees $345 billion. “It has become more favorable for companies with a weaker balance sheet. They are in a much better environment.”

The rally has made the higher-debt group more expensive. Those companies trade at 20.4 times projected adjusted earnings, according to Bloomberg data, compared with a ratio of 18.8 times for less-risky corporations. The 8.9% premium is the most since estimated profit ratios start for the baskets in 2011.

Williams, Exxon

Williams Cos., the third-largest U.S. pipeline company, has gained 14% this year, compared with 6% for Irving, Texas-based Exxon, the world’s second-largest company by market value. Investors are paying 42.5 times Tulsa, Oklahoma-based Williams’s expected adjusted earnings, compared with a ratio of 11.5 times for Exxon. Analysts estimate the smaller company’s operating profit will contract for a second year, and it has 13 times more debt than Exxon relative to assets, according to Bloomberg data.

The S&P 500 is trading at about 15 times analysts’ forecasts for 2013 adjusted income, the highest since the second quarter of 2010. That compares with an average ratio of 14.3 since 2006, Bloomberg data show. The valuation has climbed 36% since March 2009, held back as company earnings surged, the data show.

For Glyn Owen, who helps oversee $4.6 billion at Momentum Global Investment Management Ltd. in London, central-bank stimulus is delaying the inevitable by allowing companies that would have gone bankrupt to keep trading.

“Companies are being kept alive when in previous cycles they would have gone to the wall,” Owen said in a phone interview on May 14. “It’s the opposite of the creative destruction that we have seen before. We are in a very big bull market for equities, but our strategy is to stick to quality and good balance sheets.”

Subprime Crisis

The index of companies with weaker finances tumbled 63% from the S&P 500’s previous peak in October 2007 through the low in March 2009. The less-risky firms fell 44%.

The crisis that started with U.S. subprime debt defaults wiped about $11 trillion from the value of American equities between July 2007 and March 2009. The total value of U.S. shares outstanding has now reached $19.6 trillion, Bloomberg data show, having recouped all losses. Even so, only $17.1 billion of the roughly $400 billion that was pulled from U.S. equity mutual funds over the last four years came back in 2013, according to data from Washington-based Investment Company Institute.

Cash Hoards

Companies in the stronger basket have average cash balances of $1.8 billion, 33% more than that of the indebted group relative to assets, the data show. While that provides a buffer should interest rates rise, it’s also a sign of caution among chief executive officers and may help explain why indebted companies are rallying more, according to Joerg de Vries-Hippen at Allianz Global Investors.

“To have cash in the balance sheet could be very crazy at the moment,” De Vries-Hippen, who helps oversee $392 billion in Frankfurt, said in a phone interview on May 15. “When we investors have to ask companies to do something with their cash, then it is often too late.”

The more indebted stocks posted some of the market’s worst returns during periods of economic weakness since the U.S. bull market began. They fell 3.9% in 2011, trailing the S&P 500, which was unchanged, and slipped 13% from April 2 to June 1 in 2012, when concern Greece and Spain would default sent the S&P 500 to a 9.9% loss.

That changed as the year progressed. From Nov. 15, when the benchmark gauge bottomed at an almost four-month low, the weak balance sheet measure has jumped 38%, compared with a 23% rally for the broader market.

Constellation Advance

Constellation Brands, rated one level below investment- grade by both Moody’s and S&P, raised $1.55 billion last month to help fund the purchase of a remaining 50% stake in Crown Imports LLC. The company sold eight- and 10-year notes with a weighted average coupon of 4.1%, about 3 percentage points lower the average of its bonds a quarter earlier, Bloomberg data show.

The shares jumped 48% this year. Net debt for Constellation will more than double as the Victor, New York- based company wins full control of Corona beer in the U.S., according to analysts at HSBC Holdings Plc.

Tenet Healthcare is taking advantage of lower borrowing costs by using its May 15 sale of $1.05 billion in 4.375% secured notes due October 2021 to redeem its $925 million of 8.875% securities maturing 2019. Tenet’s $5.43 billion of total debt on March 31 accounted for more than 60% of assets, the highest level since at least 1989.

‘Most Baffling’

About 81% of stocks on the New York Stock Exchange are trading above their 200-day moving average, compared with a mean of 55% since 2005, according to Bloomberg data.

“One of the most baffling things to a lot of people about the market is they can’t understand why it’s up so much,” James Paulsen, the Minneapolis-based chief investment strategist at Wells Capital Management, which oversees $325 billion, said in a May 16 phone interview. “We priced a market for the end of the world that’s never occurred,” he said. “People are starting to capitulate on the end-of-the-world idea.”

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