There are many shocks to the market that investors must be wary of -- economic changes, future growth prospects, new innovators that disrupt a company's competitive advantage. One of the most fear-inducing components of a company is debt.
Debt can be dangerous. Credit card users who never pay down their principal know this to be true. And the same goes for companies. Many take on debt to finance growth.
Where debt lurks
Investors use company filings to calculate whether the company can meet its obligations. The amount of debt, the terms, the interest rate -- it's all in there.
Or is it?
Unfortunately, filings don't tell the whole story. There's a whole slew of debt that companies don't have to report on the financial statements under generally accepted accounting principles (GAAP). What kinds of debt do companies keep hidden? Pensions and operating leases, to name two. And pensions in particular are quickly becoming a dangerous red flag.
Drowning
in debt
The Pension Benefit Guaranty Corp. (PBGC) estimated a few years back that U.S. pensions have a collective $450 billion shortfall. That's a lot of hidden debt. Most of that is the result of a stock market that underperformed the expectations that companies had for their pension investments.
And both companies and workers are feeling the pain. Back when it was in bankruptcy, UAL (NASDAQ:UAUA) won approval to default on its pension obligations to more than 120,000 workers. Other airlines suffering under crushing pension obligations asked Congress last year to pass new laws that would spread billions of dollars of catch-up obligations over a 25-year period.
And then there's the story of the now nonexistent Bethlehem Steel. The company declared that its pension plan was 84% funded, but once the PBGC took it over, it discovered that Bethlehem's plan was funded by only half that amount.
Now GM (NYSE:GM) has announced an enormous restructuring of its plants, employees, and pension obligations. It's hard to tell what this means for investors, but it's pretty obvious that the company was previously running itself into the ground. The stock has been dropping for five years, and the restructuring announcement did nothing to change that course. Investors in these companies were hurt by hidden debt and eventually discovered that these companies weren't values at any price.
Risk in debt
That's because companies that can't meet their obligations are riskier investments. After all, remember that equity holders get paid last in the event of liquidation. But companies with debt aren't always losers:
|
Company |
Ticker |
Projected pension |
10-year return |
|---|---|---|---|
|
Ampex |
(NASDAQ:AMPX) |
7.80 |
(83.10%) |
|
Lucent Technologies |
(NYSE:LU) |
1.91 |
(45.60%) |
|
GenCorp |
(NYSE:GY) |
1.62 |
92.78% |
|
McDermott International |
(NYSE:MDR) |
1.50 |
182.49% |
Some of these companies would have lost you quite a bit of money, while some would have earned you great returns. The trick is knowing which ones can keep the debt threat at bay. If a company has solid long-term returns on capital, a secure market share, and sturdy competitive advantages, then it may be in a position to meet its obligations and reward investors.
That's why it pays to look at stocks holistically -- don't let one lone metric seal or sink your decision to buy or sell. While pension obligations are spooking the market today, they may be spooking them just enough for you to buy shares of a company like 3M (NYSE:MMM) at a value price. That company has been actively addressing its rising pension obligations for years now, and while those obligations weigh on the business and earnings, the company is still meeting its growth objectives.
Prepare against the shock
The market overreacts to news every day. Whether it's due to an actual deterioration in a company's fundamentals, a change in the prospects of the company's future growth, or something as simple as an earnings miss for the short term, you can find bargains on the market.
The pension obligation made Inside Value advisor Philip Durell wary of 3M, but he looked past it and saw a great business selling at a discount to intrinsic value. This process of finding bargain values when the rest of the market gets spooked is how Philip finds all his recommendations. To date, his portfolio has returned 14% vs. the market's 9%. You can even check out all his research and the service's premium discussion boards with a 30-day guest pass.
Fool research analyst Shruti Basavaraj buffers her portfolio with cotton. She does not own shares of any companies mentioned in this article. The Fool's disclosure policy is grrreat!
