David Tepper and Corporate Debt

Like most value investors, he prefers companies with little or no debt

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May 29, 2018
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In 2017, I wrote an article with this title: “David Tepper Takes Big Risks for Big Rewards.”

However, in his base portfolio, Appaloosa Management founder David Tepper (Trades, Portfolio) does not like equities with long-term debt. That became clear in researching the characteristics of the stocks he holds. The following table shows his top 10 equity holdings, as well as their debt-to-equity ratios and their interest coverage:

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Of the 10 stocks shown, only two have interest coverage of less than 10, and only two have a debt-to-equity ratio of more than 1.0.

There are many reasons to look for minimal or no debt when investing — perhaps the best is captured by the famous Peter Lynch saying, “Companies that have no debt can’t go bankrupt.” This simple, but insightful, quotation assures us that there will never be a complete loss of capital when investing in a debt-free company.

A more expansive view on debt comes from GuruFocus founder Charlie Tian’s book, “Invest Like a Guru: How to Generate Higher Returns at Reduced Risk With Value Investing,” in which he says, “A company's debt level is the most important factor when measuring its financial strength.” A company without debt has more flexibility than a company with debt, and all else being equal, no debt repayment means more cash to invest in opportunities as they arise.

GuruFocus contributor John Dorfman, who recommends a few low-debt stocks each May, says:

“In the era of super-low interest rates, which began in 2008 and perhaps is drawing to an end now, companies took advantage of low rates to borrow a lot of money.

That wasn’t necessarily wise. If the loans carried a floating rate, the burden of debt service will probably rise. Even with fixed-rate loans, the companies may have to refinance the debt on unfavorable terms. And low-debt companies enjoy strategic flexibility.”

To buttress that argument, Dorfman adds, “My low-debt picks have beaten the index 12 times out of 15, so I’d say they are batting .800. They have been profitable 13 times.”

Now, to give debt its due, it can be a good thing. When used for practical projects, it allows corporations to expand or enter new business spaces. In the long run, leverage can be good for shareholders and management.

Unfortunately, it can also be used for the wrong purposes such as buying back shares when share prices are already robust, merger and acquisition activity that has no strategic purpose other than inflating egos, or any other unprofitable activity.

Getting back to Tepper, we might argue it makes sense for him to buy equities with little debt when his central strategy is to take on distressed debt situations. More specifically, he focuses on distressed equity and debt investing. ValueWalk says, “He likes to buy into companies that are near bankruptcy. He will then sell the company’s debt when it matures or sell the stock once the company has recovered.”

It is fair to say Tepper has had a lot of experience with debt; one of his first jobs was as a credit analyst at Goldman Sachs Group Inc. (GS) before moving on to the company’s high-yield desk for eight years. Then, he started his own firm that, as noted, specialized in distressed debt. That’s a broad overview, and we would expect him to have a much more nuanced perspective on debt, of course.

Out of his total portfolio of approximately $16 billion, some $6 billion goes into the special situations while some $10 billion is in the equity column. In a sense, Tepper’s low-debt equity portfolio provides a platform from which he can move in and out of distressed plays.

The equity base also provides a place for equities that are recovering, or have recovered, from their brushes with bankruptcy. Bank of America (BAC, Financial), which made Tepper famous in the wake of the 2008 crisis, is one of them. The hedge fund manager made a very big bet that year: that the federal government would not let banks fail. Tepper bought very heavily into Bank of America and Citigroup at deep discounts and rode them to a $7 billion gain after the bailout. He sold those shares in 2015, and then bought back into Bank of America in 2017.

Finally, Tepper is a value investor who takes on seemingly big risks in the distressed area and is comfortable with those risks because of the intense scrutiny he and his team bring to bear on prospective situations. On the “base” equities, it seems he chooses no or low debt based on his experience and knowledge.

For all value investors, there is an important lesson to be learned from Tepper, which is to stick with companies that take a highly conservative position on debt.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.