John Dorfman in his Bloomberg article titled Debt Dogs of Summer Are July’s Hottest Stocks touches on something that I have also noticed. 

This market rally has been led by junk companies!

That means growth stocks from the previous bull markets and over-leveraged companies such as re-listed leveraged buyouts.

Two examples John mentions: (emphasis mine)

Human Genome Sciences Inc. acts as if it’s on steroids. Shares in the Rockville, Maryland-based biotechnology company have risen more than 400 percent in July.

Human Genome has jumped to $14.64 from $2.87 at the start of July. Last week the company and its joint-venture partner GlaxoSmithKline Plc announced positive results from a phase three clinical trial of a lupus drug, Benlysta.

The company has lost money in 29 of the past 30 quarters. Its book value (corporate net worth) was negative to the tune of $241 million as of Dec. 31. And its total debt is more than $581 million.

As for the stock, it sells for more than eight times per- share revenue, a rich multiple. And the price-to-earnings ratio is incalculable because there are no earnings yet.

I’d say investors are paying full price today for success that might be achieved in the future. As a strategy, that works once in a while. Most of the time it’s a recipe for disaster.

The other example is

Oshkosh Corp. is another debt heavy hot stock. Based in Oshkosh, Wisconsin, the company makes military trucks, fire engines and cement mixers.

The stock is up 75 percent since June 30, when Oshkosh received a $1 billion U.S. Defence Department contract to supply more than 2,200 all-terrain vehicles for the armed forces. Most or all of them will be used in Afghanistan.

Oshkosh has debt equal to about 34 times its equity. That leaves me watching from the sidelines.

I am also not a fan of investing in companies with high debt levels. John mentions that his preferred measure of debt no higher than 50% of equity, mine is 35%.

Highly leveraged companies lack the financial flexibility when it really matters and that is why I avoid them.

Just think about how many companies piled on debt buying back shares at high prices to “optimise their capital structures” and now am fighting for survival when they could be making acquisition at really attractive prices.

With banks still under capitalised, writing off bad loans and the public debt capital markets only available to the largest companies I do not think the credit markets have freed as much as the rise in equity prices indicate.

Buy over leveraged junk companies at your peril.

Tim du Toit is the editor of Eurosharelab. Kindly note that this blog is published for information purposes and is not investment advice. Please refer to our disclaimer. To subscribe to our weekly newsletter, click here.

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