Companies with exceptionally strong finances currently aren’t getting the respect they deserve. In today’s troubled economy, that may seem strange. But there’s a cause for this lack of appreciation: unusually low interest rates.
At the moment, companies with extensive borrowing don’t suffer much, while the strongest businesses get little benefit from their pristine balance sheets. Indeed, they may have trouble finding worthwhile places to invest any extra cash. But once the cost of borrowing starts rising, companies with little debt and plenty of cash on hand will deserve a premium price.
Today, the sluggish economy and the Federal Reserve‘s policy of pumping money into the banking system have combined to keep borrowing cheap and hold down the return on extra cash. As a bellwether, consider yields on TIPS, a type of Treasury security that is adjusted for inflation. At the last auction of five-year TIPS in April, the yield was negative for the first time in history. You don’t often see a lender paying interest to the borrower.
For a less arcane indicator, consider that short-term interest rates normally average a quarter to a half percentage point above inflation. Over the past 12 months, however, consumer prices have risen 3.6%, but Treasury bills currently pay far less than 1%.
It’s possible, of course, that the U.S. economy will relapse into a protracted recession and that interest rates will remain at rock bottom. But you can’t have negative real interest rates forever. Sooner or later the economy recovers and demand for money rises. And some day, the Fed will stop pumping money into the banking system (not least because that policy is limited by soaring federal debt).
When rates eventually do rise, companies that have significant borrowing will face higher costs; companies with little debt won’t. Simple logic suggests that the higher interest rates rise, the greater the premium that the shares of low-debt companies will deserve.
Moreover, there are five other reasons low-debt stocks should be appealing to today’s investors:
- Companies with superb balance sheets are less risky in financially troubled times.
- Companies with excess cash can buy back their stock if it becomes undervalued, thereby bolstering the share price.
- Companies with cash to spare can afford to increase dividends.
- Companies with their own resources can finance expansion even when banks are hesitant to lend.
- Companies with cash and a top credit rating can raise the money to buy troubled competitors when acquisition opportunities present themselves.
Of course, simply having low debt is not a guarantee that a company will prosper. But if you like a company’s prospects otherwise and it has little or no debt, it’s likely to be a bit undervalued right now.
You can create a list of such stocks to consider simply by going to a stock screener like Google’s. Set it for market capitalizations of $10 billion or more to get big companies. Then look under financial ratios and set total debt as a percentage of assets to 8 percent, say. You’ll get fewer than 80 stocks, some of which are exchange-traded funds (ETFs) that don’t count for our purposes. Among low-debt common stocks are lots of top tech names, as I wrote last week. But there are other stocks as well, some of which I own myself.
The full list includes: Applied Materials (AMAT); Automatic Data Processing (ADP); Charles Schwab (SCHW); Chevron (CVX); Coach (COH); Exxon Mobil (XOM); Intel (INTC); Microsoft (MSFT); Nike (NKE); Precision Cast Parts (PCP); T. Rowe Price (TROW); and Texas Instruments (TXN).
Empty pockets don’t ever make the grade, but God bless the stock that’s got its own.