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. 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, and this environment will be even more difficult for companies with poor credit ratings, which 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 Rent-A-Center
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, some companies can provide their own organic financing, rather than taking on debt. We call them cash cows.
Cash cows churn out gallons of free cash flow -- the cash 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 Burlington Northern Sante Fe
Two current cash cows are Sherwin-Williams
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 in (or headed for) that predicted recession, you can sleep better knowing that you own a stable of quality stocks 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. Rent-A-Center is a Motley Fool Inside Valueselection. Sherwin-Williams and SEI Investments are Motley Fool Stock Advisor recommendations. The Fool's disclosure policy was Jerry Springer's final thought on Friday's show.
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