I recently came across a new paper by Dan Rasmussen and Brian Chingono (by way of Wesley Gray's blog post on Alpha Architect ) on the viability of private equity style investing in public markets. Private equity firms buy small to mid-sized distressed companies with hopes of fixing and reselling them for a profit. Rasmussen and Chingono conclude that by investing in small, cheap, and moderately-to-highly leveraged publicly traded companies, one can replicate the returns of private equity firms while avoiding the illiquidity normally associated with PE deals.
The authors regressed several fundamental and technical features over quarterly returns on small-to-mid cap stocks, finding statistical significance for a premium on value (cheap) companies with moderate to high leverage ratios ( Long-Term Debt/Enterprise Value), falling debt (LT Debt (t) < LT Debt (t-1)) and growing asset turnover (% Revenue Growth > % Asset Growth).
The proposed explanation for this premium is centered around deleveraging via free cash flow yield. Free cash flow yield is the cash a company has left over after all its operational expenses and capital investments (buying new machines, paying salaries, keeping the lights on in the factory, etc.) divided by the company's enterprise value (market cap - debt). Debt has opposing impacts on free cash flow yield, lowering its denominator through decreased enterprise value and lowering its numerator by increasing the burden of interest payments. A higher ratio of debt to purchase price will amplify the impact purchase price (market cap) has on free cash flow yield. In other words, when you pay very little for a company relative to the debt on its books, you are maximizing free cash flow yield by lowering enterprise value more than the negative impact of interest payments on free cash flow.
As time goes on, the more free cash flow a company has, the greater their ability to pay down debt, raising enterprise value and lowering their future interest payments. The authors use the year over year changes in long term debt and asset turnover as proxies for the change in free cash flow yield.
I used the following filters on data from a call to get_fundamentals( ) to build a quarterly rebalancing strategy based on the paper's findings :
Start with companies in the 25th to 75th percentiles of market cap.
From that group, take the cheapest 25% of stocks (as defined by ln(EV)/ln(EBITDA)).
From that group, take the stocks with above median leverage ratio (LT Debt/EV).
From there, only take companies with positive debt paydown (LT Debt (t) < LT Debt (t-1)).
And finally, take only companies with growing asset turnover (% Revenue Growth > % Asset Growth).
This first pass is generally profitable but with a sizable max-drawdown ('08 was not a good time to be long leverage!) and high beta. Ten points to anyone who can develop a hedged version of this strategy!
