Debt and Investor returns

Growth is rarely possible without some amount of debt, at least at the initial stage if not later. But while some companies try to pay of their debt as soon as situation becomes better and internal accruals can fund their needs, some promoters get addicted to cheap debt and many a time end up destroying what was build over decades, even generations.

While the advise generally is to invest in good companies which have very little (or better Zero debt), the question I am asking here, is what is the difference in returns. To get to the bottom of that question, I did a small test.

I selected the top 50 (based on Friday’s Market Cap) Debt free companies and selected the top 50 companies with the largest debt. Since Banks / NBFC companies cannot go without debt, I excluded such financial firms from my test. The test though suffers from Survivor bias since all the data is from Friday and any company that has got delisted from exchanges due to Debt goes scot-free as such.

The first chart is of the returns generated by investing 10,000 into each company shares (since this is more of a theoretical exercise, fractional shares were allowed to be bought).

While one would expect Zero Debt companies to beat High Debt companies, the picture above seems to indicate that while Zero Debt companies would have beaten High Debt (though both end in losses, remember our total investment was 5,00,000.00) if you had invested 1 year back, on the shorter term, the High Debt companies have given stronger returns if the same was done just a month back. A Quarter back, it was more or less a draw.

What does the above data show? To me, it suggests the importance of timing regardless of the kind of company you are investing in. Now, lets explore this idea and use a much bigger data set (in terms of look back time). Instead of the max period being 1 year, how about we see how this would have worked over 3 / 5 and 7 years.

There is a issue here though – some companies were not even trading 5 / 7 years ago. To make the comparison uniform, I have assumed that they generated Zero returns (i.e., capital remained the same at the end of the period).

While high debt companies may have given some amount of competition on shorter time frames, on longer time frames, its beaten black and blue. Of course, do note that one will need to make a more detailed test since 7 years back, some of today’s high debt companies may actually have had low or even Zero (looking at the list I doubt, but better to be wary than accept facts blindly).