Credit events might be rare, but they can trigger big stock moves. Traders looking to understand why stocks go up and down need to understand this powerful catalyst.
Think about it like this: Many companies sit on a bedrock of borrowed money, like a house on a foundation. If that foundation suddenly collapses, the whole structure goes down. Likewise, fixing a broken foundation can be the surest way to repair a damaged house.
Other catalysts described in this series, like margins or volumes, are like wind storms beating against the house. They’re more common but are less likely to knock it over quickly. Credit is the very foundation under the house. Here are some basic principles.
First, the big moves happen when companies go from good credits to bad credits, or vice versa. The recent decline in General Electric (GE) is a classic example.
At one point, lenders virtually threw money at GE because it had perfect AAA credit ratings. That kept its borrowing costs low and allowed it to tap markets whenever it wanted.
What happened when those things changed? First, interest rates go up. That increases expenses on the income statement, hurting net income. In this case, credit squeezes profit margins.
Second, now that it’s harder to borrow, management may need to liquidate assets or even sell shares to cover debt coming due. Divestitures create uncertainty (bad for multiples), while issuing more stock is obviously bad for the price of existing shares. A double whammy.
Another important thing about the credit market is that lenders often have more information than the stock market. Believe it or not, companies disclose secrets to banks that never appear in public SEC filings. Traders can’t see these memos, but they can track them by noticing stories like “XYZ company increases credit facility and lowers cost.”
Be on the lookout for announcements involving loans (aka “credit facilities” or “revolvers”) getting upsized at lower rates. The bankers might know something positive — even if you don’t.
Sometimes credit analysts at agencies like Moody’s and Standard & Poor’s also spot these turns. However, be careful because most headlines from these firms is just background noise.
How to easily identify companies with a lot of debt or potential credit risk? Look for enterprise value significantly above market capitalization. This might sound complicated, but it’s simple if you think about a house with a mortgage.
Say you buy a house for $500,000. That’s its enterprise value.
If you have a $400,000 loan, your equity is $100,000. Say the house loses 20 percent of its value. Your entire equity is wiped out, like the stock of a bankrupt company going to zero.
But say you only have a $200,000 loan. In that case, a 20 percent drop in value would only erase one-third of your equity.
Either way, the starting enterprise value is $500,000. In the first case, it’s 4 times market cap. In the second case it’s less than half the market cap. That’s why leveraged companies are more volatile.
Most readers understand this simple principle of equity on a house. But you might not have known that it’s easily found on companies by comparing enterprise value to market cap. The bigger the enterprise value is versus market cap, the more debt. Don’t overthink it.
The most common credit trend is probably the debt-fueled selloff. Examples of this include GE, Chesapeake Energy (CHK), J.C. Penney (JCP) and Sears (now bankrupt). In these cases, a company’s assets lose value. Because there’s so much debt, the declines are simply leveraged.
Market dynamics and sentiment obviously magnify the trend because, the lower it goes, the less willing banks are to help it refinance IOUs coming due. Borrowing costs rise. That hurts profits further, in turn reducing the value of assets even more. Companies like this also struggle to issue new stock to pay debt, further pushing its shares down. Blood in the water.
This vicious cycle often occurs on companies that were “once great” but have now fallen on hard times. Remember Eastman Kodak? By the way, Mattel (MAT) and Teva Pharmaceuticals (TEVA) could be in the midst of crumbling now.
Also watch for companies getting dropped from an index like the S&P 500. That’s another sign of the vultures circling.
The process can also go in reverse when a company has a turnaround: An improving business raises the value of assets. Banks are more willing to lend. Interest expense falls. Just look at names like Advanced Micro Devices (AMD), Petrobras (PBR), NRG Energy (NRG) and Community Health (CYH).
In conclusion, there are times when credit trends dominate movement in a company’s share price. It’s not especially common but it can overwhelm all other considerations when it’s in play. We hope this post helps you understand enough of the basics to recognize this phenomenon when it occurs for your own investing.