It's not a good time for debt.
Ever since the last bear market, corporate debt rates have been relatively favorable, so it's been easy for companies to load up on low-interest, tax-deductible debt that also reduced their cost of capital. Taking on debt, after all, is typically cheaper than issuing new equity.
The times, they will be a-changing, however, as the reality of higher inflation and a weakening dollar will eventually force the Federal Reserve to raise rates.
If that trend continues, companies with significant debt will face increased interest expenses, which will put increased pressure on their earnings growth.
Feeling the pinch
So, what does this mean for you? We're never fond of substantial debt, but this environment will be particularly difficult for companies with poor credit ratings that require higher yields to satisfy debt investors.
Therefore, you should use caution approaching companies with non-investment-grade bond ratings, especially if they fall into the "highly speculative" range. At current rates, companies with non-investment-grade ratings such as Ameristar Casinos (Nasdaq: ASCA ) , Lennar (NYSE: LEN ) , and Las Vegas Sands (NYSE: LVS ) will have to entice investors with bonds yielding around 8%-9% for new 10-year debt. Those yields may go even higher.
If a company is paying all of its earnings into debt expenses, there's not much left for the shareholders.
Milk the cash cows
In every market, there are companies that can provide their own organic financing rather than take on debt. We call them cash cows.
Cash cows are companies that churn out gallons of free cash flow -- the cash that's left over after normal capital spending. There are good reasons to own stock in companies that generate strong free cash flow, and in a down market, those reasons become even more attractive.
When times are tough and interest rates are high, a company with free cash flow can use the excess cash to invest in itself, so that when the economy finally turns around, the company will be in a better position to take advantage of the good times.
Two stellar examples during the last bear market were Best Buy (NYSE: BBY ) and Express Scripts (Nasdaq: ESRX ) Both companies had positive free cash flows in 2000, carried healthy balance sheets, and were thus able to focus on building their core businesses. By the time the market recovered, they were able to reap the benefits -- since March 2003, these stocks have risen 142% and 362%, respectively.
Two current cash cows are Netflix (Nasdaq: NFLX ) and GameStop (NYSE: GME ) . Despite tremendous gains from both companies over the past three years, the stocks are well off their 52-week highs, but they nevertheless continue to generate gobs of free cash flow. Both are world-class brands, and the extra cash on hand will serve them well, no matter what the economy does next.
It does a portfolio good
It's always a good time to make sure you're invested in financially sound companies with strong business models and reasonable valuations. But now is a great time. Even if we are headed for that predicted recession, you can sleep more easily knowing that you own a stable of quality stocks that are worth holding for the long term.
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This article was originally published March 20, 2008. It has been updated.
Todd Wenning wants you to promise him you'll never go bungee-jumping in Mexico. They just don't have the regulations in place down there. He does not own shares of any company mentioned. Ameristar Casinos is a Motley Fool Hidden Gems selection. Best Buy is an Inside Value pick. Netflix, GameStop, and Best Buy are Stock Advisor picks. The Fool owns shares of Best Buy. The Fool's disclosure policy was Jerry Springer's final thought on Friday's show.