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Outperformance of debt free firms
Tue, 18 Feb Pre-Open

The Indian economy is in a state of low growth. The situation is not likely to improve any time soon. Several corporate houses are struggling in the face of falling demand for their products. Others are facing issues with government clearances and regulations. However the most serious problem facing Indian companies today is not the external economic situation that they face. Rather, it is one which is self-inflicted.

According to the Economic Times, the biggest issue that is hitting India Inc hard is the overhang of debt. With the Reserve bank of India (RBI) raising interest rates to combat inflation, the situation seems dire for many companies which have too much debt on their balance sheet. As the article points out, the companies which have stayed away from debt over the last five years have done very well for themselves.

These firms have not had to worry about high interest rates as their debt levels were either very low or nil. This has greatly helped them post strong bottomline numbers over the years. Also, being debt free brings with it another advantage. These companies can choose to re-invest the surplus cash flow back into their business and gain a competitive advantage over their peers who might be struggling to make interest payments. Over time, all other things being equal, such firms can significantly outperform other companies in its industry.

The article mentions stocks from various sectors like FMCG, IT, MNC Pharma and Auto which have outperformed the market by a huge margin. In stark contrast, companies with high debt levels have given very poor returns over the last few years. So does this mean that one should invest only in debt free or low debt companies?

The answer is not so simple. While the debt/equity ratio is a great way to filter out bad companies, it cannot be the only criteria. A company with zero debt may, at times, be at a disadvantage in an economic upturn. This can happen if a competitor were to take advantage of low interest rates to build up its competitive position. Size is also a factor. A large company may be able to service a higher level of debt than a smaller company in the same industry. Therefore, having low debt stocks in one's portfolio is great; it should not be the only criteria for selecting good stocks.

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