An Investment Strategy Based on Gearing Ratio

Gulnur Muradoglu*
Morten Bakke**
Gyrid L.Kvernes***

Cass Business School

Working Paper No:2004-002

Abstract

This paper investigates the predictive ability of gearing in the long term for UK
firms. Robustness tests are carried out to examine the returns in excess of that
attainable using book to market, price earnings and size as risk factors. We show
that by pursuing an investment strategy based on gearing ratios and a holding
period of three years returns of 9.9% in excess of market return are attainable.
Excess returns, up to 21% are attainable when portfolios are constructed based
on price earnings ratio and gearing ratio.

Running Title: Investment Strategy Based on Gearing

*
Corresponding Author. Cass Business School, City of London, 106 Bunhill Row, London EC1Y 8TZ.
Tel:020 7040 0124, Fax:020 7040 8881, e-mail:[email protected]
**
Collateral Management Credit First Suisse Boston, Tel: +44 207 888 5298 ,Fax: +44 207 883 7987
***
Travelmannstrasse 48-50 23564 Lübeck Germany.
Introduction

This paper aim at constructing a long term investment strategy based on gearing
ratios. We test for the robustness of our results using frequently used ratios such
as book to market, price earnings and size ratios. Companies may use our
results by identifying the debt to equity ratio that would maximise shareholders’
value. Investors may pinpoint potential growth stocks according to companies’
gearing levels.

The gearing ratio is critical to the evaluation of a company’s financial structure

and bankruptcy risk. A gearing ratio may take many forms, but it usually
examines the relative relationship between debt, equity and assets of a
company. The gearing ratio used in this paper measures total debt over total
capital employed, which is according to Gardiner (1995), in line with what most
analysts use.

Prior research has looked at various factors one may use for predicting abnormal
returns. The research has mainly been focused around price earnings ratio, book
to market, and size but has ignored gearing as a risk factor to a considerable
extent. Campbell & Shiller (1998), Lakonishok, Shleifer & Vishny (1994) and
Jaffe, Keim & Westerfield (1989) have shown that price-earnings ratios can be
used as predicting factors for stock returns. Book to market ratio as a factor
explaining excess returns have been investigated by Chan, Hamao & Lakonishok
(1991) and Fama & French (1992). Both studies show that a firm's book value of
a stock to the market's assessment of its value should be direct indicator of the
its future prospects. Banz (1981)and Fama and French (1992) documented a
significant relation between firm size and security returns for non-financial firms.
Over the past decade the three factor model of Fama- French (1995) that
employs size, book to market and price-earnings ratios as risk factors has been
tested in various world markets and has been used extensively by practitioners.
Work on gearing ratios as risk factors or as a predictor of excess returns has
been limited. Hull (1999) investigated whether the average industry leverage is
the optimum for the companies in the respective industry segments. He shows
that stock returns for firms "moving away" from the industry leverage norm are
significantly more negative than returns for firms "moving closer to" the norm.
Bowen, Daley and Huber (1982) report that industry average leverage ratios tend
to be relatively stable over time, which imply that these average ratios is seen as
being optimal. This coincide with Hull’s (1999) findings and indicates that there
might be an understanding in the respective industries that an optimal debt to
equity structure exists and that this optimum is close to the industry average.
Bhandari (1988) on the other hand, argues that an increase in the debt to equity
ratio of a company will increase the risk of its common equity and hence the
increased risk should be compensated by higher returns. He further argues that
leverage may be a good proxy for risk, in addition to beta.

Muradoglu and Whittington (2001) investigated the predictability of stock returns

using gearing ratios in the UK. They show that companies with moderately low
leverage enjoy substantial higher returns than the market. They argue that low-
gearing firms have the opportunity to increase leverage notably and it is this
opportunity that is valued strongly. However they do not conduct any robustness
tests and we do not know if a strategy based on gearing yields abnormal returns
in excess of the popularly used risk factors such as size, book to market and
price earnings ratios. We fill this gap in this study. We work with UK non-financial
companies and employ the above mentioned factors in addition to gearing in
estimating excess returns in the long run.

Data and Methodology

Our research period covers the period from May 1st 1991 to end of April 2002.
Share prices are from DataStream and accounting data is from FactSet Ltd's
database. Balance sheet data is annual while stock prices are collected on a
daily basis. The fiscal year for companies listed on the FTSE 100 may end at
different dates throughout the calendar year, since there is no requirement in the
UK when the financial year should end. Most companies had a Balance Sheet
date of 31st of March (40%) and 31st of December, (37%) and most annual
reports would have been published by May the 1st each year. Therefore we start
accumulating abnormal returns as of this date. We work with 52 UK non-financial
companies included in the FTSE-100. Out of 100 companies included in FTSE-
100, 25 are excluded from the sample because they did not have matching year-
end leverage ratios and stock prices available for all subsequent years. A total of
14 financial companies and 9 companies that changed their fiscal period during
our research period are also excluded from the final sample. The sub-samples
based on BM, MCap and PE ratio include 45, 45 and 49 companies respectively
due to our comparable and continuous data requirements over the research
period.

We use the following gearing ratio, Following Muradoglu and Whittington (2001)
to represent the leverage of the companies in the sample. It is the ratio of total
debt to total financing of the firm.

Gearing Ratio = Preference Shares + Subordinated Debt + Total Loans + Short-term Loans (1)
Total Liabilities + Minority Interest + Non-Equity Reserves + Preferred Stock + Common Equity

The shares in our sample are first divided into two different portfolios, companies
with the highest gearing being in portfolio and those with lowest gearing being in
portfolio on an annual basis. We form the portfolios as of the 1st of May, following
the release of the financial statements and we have a three-year holding period
for each portfolio. Each portfolio is rolled over on year by year basis. For
example, portfolio HG1 consist of companies with high gearing and their
cumulative abnormal returns are calculated from 1991 to 1994. The three year
holding period consists of 752 to 759 working days, depending on which year the
portfolio was constructed and captures the long term.

Next we divide each gearing sample into two book-to-market sub-samples, Low
book-to-market and high book-to-market respectively. We then have four
portfolios that represent (1) low book-to-market and low gearing companies, (2)
low book-to-market and high gearing, (3) high book-to-market and low gearing
and (4) high book-to-market and high gearing. We repeat the same exercise with
sub-samples based on size, which is defined as total market capitalisation of the
company, and Price-earnings (PE) ratios.

The procedure and test statistics below are based on Barber & Lyon (1997) and
Vijh (1999) papers. The return for firm (i) for day (t) is defined as Rit and is
continuously compounded by taking the log differences of two consecutive
prices. Rmt is the market return on day t, calculated as the log differences of
index levels of FTSE 100 for two consecutive days. The market adjusted
abnormal returns and cumulative abnormal returns for day t are calculated as
follows:

ARit = Rit - Rmt (2)

752
CARit = ∑ ARit (3)
t =1

We use the following parametric test statistic that follows a Student t-distribution:

TCAR = CARit /(σ CAR / n) (4)

it

where CAR it represents the sample average cumulative abnormal returns and
σ CAR is the cross sectional sample standard deviations of cumulative abnormal
returns for the sample of firms.
Findings

The average gearing ratio was 17.6% for the low gearing (LG) companies and
26.1% for the high gearing (HG) companies with respective standard deviations
of 11.63% and 13.24%. Table 1 reports the CARs attainable in three years by the
fourteen alternative portfolios we have constructed to represent different
investment strategies. By investing in low gearing (LG) companies an average
excess return of 9.9% would be attainable over a three year holding period. A
strategy pursuing highly geared (HG) companies does not yield any significant
excess returns.

***** insert table 1 here *****

When we base our portfolios on gearing and price earnings (PE) ratios, CARs
are significantly different from zero for all four portfolios. Low PE and low gearing
companies outperform the market by a substantial 21.3% in three years.
Companies with low PE and high gearing ratios also outperform the market by
9.6% which must be attributed to the low PE ratio. Companies with high PE and
low gearing ratios under perform with an average CAR of –11.7% and companies
with high PE and high gearing ratios under perform with an average CAR of –
10.0%.

When we base our portfolios on gearing and book-to-market ratio, none of the
CARs reported in Table 1 are significant. This indicates that excess returns
attainable from low gearing firms can not be improved considering their book-to
market ratios. When we base our portfolios on gearing and size, portfolios
constructed based on high gearing, have significant excess returns. Small
companies with high gearing earn 8.8% in excess of the market while large
companies with high gearing earn 9.7% less than the market. This can clearly be
attributed to the size effect.

Conclusions
Companies with low gearing ratios outperform the market in the long run, by
almost 10% in three years. A low debt to equity ratio is an attractive feature for
investors as it reduces financial risks and provides the companies with the
opportunity to raise more debt financing in the future. Returns to high gearing
companies do not deviate significantly from the benchmark index. This may well
be due to the higher financial risk of these companies that might make investors
reluctant to invest in them.

We have conducted robustness tests using Price Earnings, Book to Market and
Market Capitalisation as alternative and popularly used risk factors. Book-to-
Market ratio does not have any significant contributions to excess returns. Low
Price Earnings in conjunction with low Gearing generates the highest excess
returns of more than 21%. Low PE companies generate excess returns
regardless of the gearing level and low gearing companies generate excess
returns regardless of the PE level. Excess returns are accentuated when low PE
companies are also low PE companies. Therefore, an investor pursuing a two-
factor model investment strategy with low price earnings and low gearing would
be more strongly rewarded than investors pursuing a low gearing strategy only.

When testing for size, the only portfolio generating significant positive excess
returns was the portfolio consisting of small companies and high gearing.
However this portfolio has excess returns of 8.8% which is below the excess
return on low gearing ratio firms. Small companies being in a fast growth period
may have to fund this growth by raising debt, hence the high gearing. Note here
that the portfolio of large companies with high gearing generated a negative CAR
of slightly less than -10%. Investors may not believe in further growth to be
financed predominantly by debt or investors may further discount those
companies, as their ability to raise additional debt finance may be limited.

Our results indicate that companies, when choosing their optimal debt to equity
mix, must consider the advantages of low gearing. Investors prefer low gearing in
general. High gearing may be attractive for small companies to finance fast
growth.
References

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 Table 1
Cumulative Abnormal Returns for Investment Strategies
Based on Gearing
Low Gearing High Gearing

Low Gearing 0.0992*

High Gearing -0.0154*

Low PE 0.2130* 0.0962*

High PE -0.1002* -0.1166*

Low BM -0.0239 -0.0140

High BM -0.0448 -0.0055

Low Market Capitalisation -0.0031 0.0884*

High Market Capitalisation -0.0676 -0.0969*

Notes: Table 1 reports the average CARs for the research period from nine separate portfolio
foundation years with three year holding periods. For example the low gearing-low PE portfolio is
formed every year on May1st for nine consecutive years and the average CAR for three years
holding period is 21.30%. (*) indicates significance at 1% level.