The Falkenstein Proof

Because I’m a huge finance nerd, one of my very favorite things to come across is a piece of research that either debunks or proves one of those old Wall Street chestnuts that people are fond of repeating.

There’s an old stock-picking maxim I learned (the hard way) that goes:

“You can like the debt and hate the equity, but you can’t like the equity and hate the debt.”

Put simply, when analyzing a company’s capital structure, if the bonds look like a bad risk you can expect nothing good to come of holding that company’s stock.  Even the most basic credit research on Lehman Brothers, Bear Stearns, Enron and Worldcom would have kept you far away from the stocks of these over-leveraged fiascos – and that’s including the fact that a lot of the debt was even further obscured by accounting shenanigans.

That said, a company’s stock price may not seem like a very attractive buy but there may still be reason to want to buy the bonds.  Johnson & Johnson ($JNJ) in 2011 is a great example – here’s a company with months and months of horrendous recall headlines from Children’s Tylenol (off the shelves for 16 months) to Motrin.  The company also faces major growth hurdles from every angle – from the implementation of Obamacare to the perma-fear of patent expiry.  Nothing good happening stock-wise and yet there is no reason to believe that JNJ bonds are anything but money-good.

Now of course, this rule about having to like the bond in order to like the stock comes to us from the quaint days of yore, back before the year 2000 when people actually analyzed individual companies and intended to own them for more than 11 seconds,  But still, it’s one of the best rules of thumb I can think of for security selection over time.

And now we’ve got another piece of evidence telling us that the principles behind this concept are sound.  Blogger and Quant Erik Falkenstein has a good chart and data set up at his site showing the negative correlation between high-risk debt ratings and long-term stock performance…

The chart above excludes financial companies – they are very much their own animals in a case like this.

The lesson is to pay attention when a stockpicker tells you that he or she pays real attention to the credit side in addition to whatever work they’re doing on equity analysis…chances are it means that he or she gets this concept and won’t be as prone to the underperformance that comes from investing in a low credit quality issuer’s stock.

Erik turns up some interesting stats on the beta, volatility and stock returns for each credit rating, the sweet spot appears to be single-A.  Head over below for the data and explanation.

Source:

Stock Returns by Debt Rating (Falkenblog)