Equity has a credit blind spot. 95% of Russell 3000 companies issue debt, 75% of which is sub-investment grade. Equity investors study stock price movements but often ignore credit market signals. However, when a company's credit deteriorates, its equity follows.

Traditional equity research has a blind spot: Credit. 95% of companies within the Russell 3000 index issue debt, 75% of which is sub-investment grade*. Equity investors study the price movements on stocks but often ignore credit market signals. This is a mistake. If the credit of a company deteriorates, the equity will follow.

P/E, P/S, and P/B ratios ignore both outstanding debt and the cashflow statement, key components to a credit analysis. A better metric would be the EV/FCF ratio, which measures free cash flow generated to service debt and return cash to shareholders.

Companies with low EV/FCF multiples have historically exhibited outsized returns. While not a perfect metric, an EV/FCF analysis highlights the benefit of credit-equity research integration. Furthermore, low EV/FCF companies are positioned to benefit from the recent value shift that has been building momentum since October.

Russell 3000 Index: 20 Year Returns by EV/FCF Quintile​​​​

As of 10/31/2019. Source: Bloomberg. Enterprise value to trailing 12-month free cash flow, rebalanced monthly.

Integrated Credit and Equity Analysis 


Credit Market Analysis vs Equity Market Analysis. The key difference between credit and equity investors is incentives. Credit investors have limited upside while equity investors have unlimited upside. The credit investor is therefore heavily incentivized to sniff out trouble to avoid losses, focusing on cash flow metrics over accounting profit. While an equity investor focuses on improving sales and margin potential, they often miss deteriorating bond prices, issuer ratings, or maturity walls.

Penn Capital first determines if a company is credit worthy before considering an equity investment. The credit market provides strong signals, for both individual companies and the overall market, that can improve equity returns. Credit and equity research integration can enhance the depth and breadth of traditional equity analysis.

For more information on the topic, our research can be found here.

A PDF version can be found here.

*Russell 3000 Index companies per S&P issuer ratings as of 10/31/2019, source: Bloomberg.

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The Russell 3000 Index is a market-capitalization-weighted equity index maintained by the FTSE Russell that provides exposure to the entire U.S. stock market. The index tracks the performance of the 3,000 largest U.S.-traded stocks which represent about 98% of all U.S incorporated equity securities.

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