Does Debt Matter?

Since the beginning of 2006, I've been mildly obsessed with studying the top stocks of the past 10 years. I've reached two conclusions:

1. It pays to look at small caps.
2. Management matters.

Small companies with superior CEOs will give you a head start on market-beating returns, but I thought there would be more indicators. So far, I've been wrong.

The quandary of cash
Before starting my analysis, I hypothesized that profits 10 years ago would correlate with returns. They don't. I also thought that strong balance sheets 10 years ago would correlate with returns. Nope.

That came as a shock to me. I was taught to look for small caps with substantially more cash than debt. Yet on my list of the 100 top small caps of the past decade, there's no evidence that a company's cash/debt position matters. Here's a sampling:

A few have lots of cash and no debt, while others have substantially more debt than cash.

Debt diligence
Many individual investors out there are -- like me -- wary of debt. Sure, it's nice for a company to have more cash than debt, but debt is not evil. A lot of times, companies take on debt for less than the cost of equity -- and when a company can earn more that the cost of servicing its debt, that's a moneymaker right there.

The key is to look at a company's cash/debt position in context. Why does a company have so much cash or debt? What is it planning to do with it? What are the costs? What are the potential returns?

Upscale grocer Whole Foods used its debt to fund growth. That worked out quite well. Today, Whole Foods has almost paid off all of its debt and hasn't had to add any more debt to fund its incredible growth story. The company used debt when it needed it, used it well, and was never overwhelmed by it. That's an optimal use of financing.

Pharmaceutical giant Gilead Sciences, on the other hand, wasn't profitable 10 years ago. In fact, it was running $20 million annual losses. That's not unusual, however, for a pharmaceutical company as it works to get its research and development pipeline to market. Since it wasn't profitable, Gilead probably wasn't able to get debt at decent terms. Thus, it did equity financing. But even though Gilead had no debt, it was a riskier proposition that Whole Foods given the nature of its industry.

The Foolish bottom line
Different companies benefit from different capital structures. By limiting your investments to companies with more cash than debt, you may miss many of tomorrow's great returns.

Our goal at Motley Fool Hidden Gems is to help investors put more great small caps in their portfolios. A few months back, senior analyst Bill Mann dug up Fairmont Hotels & Resorts for subscribers. While the company's $500 million debt position looked ominous, Bill correctly noted that it didn't pose a problem.

Fairmont has since been bought out by Saudi Arabia's Kingdom Holding at a nice 30% premium for Hidden Gems subscribers. If you'd like to join us as we try to uncover the next Whole Foods, the next Gilead, and the next Fairmont -- companies that are well-managed and operate in the best interests of shareholders -- click here. Be our guest free for 30 days, with no obligation to subscribe.

This article was originally published as "The Market's Capital Opportunities" on Feb. 24, 2006. It has been updated.

Tim Hanson does not own shares of any company mentioned in this article. Best Buy and Whole Foods Market are Stock Advisor recommendations. No Fool is too cool fordisclosure... and Tim's pretty darn cool.