The other debt trap

What follows is a test of that possibility. As such, it’s the other half of what we began two months ago (Investors Chronicle, 1 March 2019) when we showed that rising debt ratios and falling share prices tend to go hand in hand.

Miserably, the reverse does not seem to hold good. In other words – and based on an admittedly small sample – there is not a consistent sign that falling debt ratios drive share prices higher. If anything, and almost perversely, the reverse is true – declining debt metrics accompany a drop in share prices.

The findings are quantified in the tables. Tables 1 and 2 use the same raw data as we used to examine the consequence of rising debt ratios, the 780 or so companies whose shares comprise the FTSE Aim All-Share index. We focused on Aim-traded companies because their share values are likely to be especially sensitive to changes in debt levels. Values are likely to be under pressure when debt ratios rise since these companies may lack the size and longevity that protects against the worst effects of debt. Conversely, when debt ratios fall, intuition suggests the opposite may apply, implying that share values will bounce.

The metric we used was each company’s net debt to its ‘Ebitda’ (basically, cash profits before interest and tax) and we used the same data as in our 1 March feature, prices from a date in early February 2019 and two years before that. Then we filtered according to two criteria.

The first filter – see Table 1 – left just 24 companies whose debt/ebitda ratio was at least 3.6 times in February 2017 (ie, above the average of 118 companies that made an interim cut) and lower than that in 2019. In other words, whether because borrowings had fallen or profits had risen or both, debt lay lighter on each company, implicitly releasing more profit for shareholders.

The second filter – Table 2 – simply took all companies whose debt ratio, regardless of where it started, had fallen far and fast between the two dates (by at least 40 per cent). That left just 31 companies.

The share prices of the 24 with high-but-falling debt ratios (Table 1) averaged an 18 per cent fall during the period, while the Aim All-Share index effectively stood still. Just seven of the 24 shares rose in the period and only one – Iofina (IOF) – rose spectacularly. Meanwhile, some fell horribly. Shares in Redhall (RHL) were down 82 per cent and those in DekelOil Public (DKL) fell 69 per cent.

The variation shown in Table 2 produced a result closer to intuition. From a sample of 31, there was an average price rise – 2 per cent – although even that was only made possible by the clear outlier, Anglo Asian Mining (AAZ), whose price rose 279 per cent. And even in this sample, there were more fallers than risers – 18 to 13.

Our remaining throw of the dice – as it were – was to consider whether we were missing something insightful because share price movements might lag changes in debt ratios; the logic being that it may take a while for share prices to catch up with the reality of falling debt levels. So we checked to see if a big drop in debt/Ebitda in year one (at least 25 per cent) was likely to result in a rising share price in year two.

So to have a bigger sample to work on, we took data for changes in debt-to-Ebitda for each of the past four years to early March and changes to share prices for each of the past three. For example, we compared changes in the debt ratio in the year to March 2016 with share price movements in the year to March 2017.

The results are in Table 3, which aggregates data from three sets of year-on-year comparisons ending with March 2019 on March 2018. Of the 66 instances, share prices rose 27 times and fell 39 times for an average gain of 2 per cent. Within each discrete year-on-year comparison, average price changes failed to beat the Aim All-Share index. In the year to March 2019 (driven by debt changes in the year to March 2018) the average change was minus 15 per cent against minus 12 per cent for the Aim All-Share. The two earlier periods produced minus 9 per cent against plus 13 per cent for the All-Share and an average gain of 23 per cent against a gain of 30 per cent for the All-Share.

True, the results are not conclusive. The data sets aren’t big enough to be definitive. But preliminary evidence provides no incentive to churn more data. More important, it fails to show that there is a quick and easy investment tactic linked to falling debt ratios. Better to know that than not to know it. Even so, it’s a pity.