Backtest on Debt to Equity Ratio

Having always stressed on investing in companies that are not highly leveraged, I chanced upon this backtest on debt to equity ratio study done by Fat Pitch Financials and found the results rather surprising.

A brief overview of the study is as follows:

  1. No OTC stocks.
  2. No ADRs.
  3. Liquidity test. The average daily total amount traded over the past 60 trading days must be larger than $100,000.
  4. Market Cap > $50 million.
  5. Price > $1. True penny stocks are excluded due to various information issues and manipulation of these stocks.
  6. Total Debt to Total Equity Ratio not missing. This filter insures we are looking at stocks that actually have data on the total debt to equity ratio.

Having the test run the data from 2000 to 2013 it showed that the first quintile under-performed the S&P500, whereas the fifth quintile out-performed the index. This was rather surprising given how we have always stressed that firms that are not highly leveraged tend to be the ones that survives and outperform in the long run.

My Thoughts

Thinking about it, I felt that one way to rationalise this occurrence would be due to the current low interest rate environment. Given how interest rates have been kept so low since the Global Financial Crisis, companies that have not taken on some form of debt would essentially be at a disadvantage compared to those who are leveraged. Furthermore, how we have always looked at leverage is not as a standalone metric but coupled with other metrics. Hence, perhaps combining both the glamor and fifth quintile debt to equity stocks would actually not result in such a phenomenon. However, as we do not know how to properly carry out such a backtest, we are unable to verify our hypothesis.

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Backtest on Debt to Equity Ratio
Backtest on Debt to Equity Ratio