Investment Factors: The Balance Sheet
Balance Sheet quality is a commonly used Factor in a fundamental investment process.
In this post we examine:
- Why strong balance sheets are good.
- What makes a strong balance sheet.
The Good things about Good Balance Sheets
On one level, understanding balance sheet strength (or weakness) is simply the price of admission for being a fundamental investor. It may not provide competitive advantage, but without it you risk being the patsy at the table.
However, because the benefits of a good balance sheet work on so many levels it is arguable that understanding this simple factor can be a major source of improved risk adjusted returns.
Good balance sheets provide benefits to investors on two levels.
First, they provide fundamental benefits to the company:
- They allow the company to maintain and improve its long-term competitive position via acquisitions and/or new product development. Especially the flexibility to do this cheaply at the bottom of the cycle.
- They provide a cheap source of incremental capital to fund growth, either organic or acquisition. Using cash or debt rather than equity provides much better near term earnings leverage.
- Even without growth they can be used to leverage organic returns (ROFE) into higher equity returns (ROE) via dividends, capital returns and buybacks.
- They buy a company time to execute. This is true of both growth initiatives and turnarounds. If you think of an investment as a call option on the future, a strong balance sheet increases the duration and value of that option.
Although these benefits are in theory transparent, experience suggests they are generally not fully priced by the market. Hence the tendency of shares to go up when announcing EPS accretive acquisitions.
In addition to company fundamentals, good balance sheets provide benefits at the investor level. They make it easier to manage emotions and portfolio positioning. For example, if the share price falls after purchase, but your thesis remains intact, a strong balance sheet enables you to average down without the risk of permanent share price destruction from a distressed asset sale or capital raising. This is a common situation as good ideas are often the most out of favor and subject to a lot of short-term volatility. Personally, this element has been a major driver of my long-term investment returns.
Weak balance sheets generate negative costs on the fundamental points above – they limit the ability to stay competitive via investment, put dividends at risk and can lead to permanent capital destruction via forced asset sales or distressed capital raisings. But perhaps most importantly, if you buy the shares of a highly geared company and the share price starts to fall, you cannot safely buy more. Indeed, you may need to sell as one of the above triggers comes into play.
However, there are at least two ways in which poor balance sheets can be good for investors.
Firstly – a geared equity value offers leverage if the company is growing in value. Assume two companies that both have an enterprise value of 100, but one is debt free (100% equity value) and the other has 50% debt/50% equity. If the enterprise value increases to 125 – in the first instance you have made 25% return on your equity (25/100), in the second 50% (25/50). If you have clear evidence that company performance is improving, you can buy a highly leveraged stock.
Secondly, weak balance sheets can focus management. Rather than having money burn a hole in their pocket, leading to waste, a weak balance sheet can focus management on costs, jettisoning non-core assets etc.
These last two categories can be highly profitable. But they are hard work – you have to watch very closely to make sure things are going in the right direction whilst at the same time hoping there are no external shocks. It’s a recipe for sleepless nights! Whilst I don’t recommend it, arguably the benefits of the first factor above are better obtained by adding leverage at a portfolio, rather than company level.
What constitutes a good balance sheet?
There are five broad considerations for an analyst in determining whether a company has a strong or weak balance sheet:
- Realisable Value: Are there assets (or liabilities) that offer the potential to increase (or detract from) the fundamental or perceived value of the company? For example, non-core land on balance sheet held below market value that can be sold to create an uplift in perceived value;
- Optional value: Does the surplus cash on the balance sheet provide the optionality to deploy capital in a way that will create real (high returning) or perceived (EPS accretive) value? Alternatively, does the balance sheet require the company to release capital in a way that destroys real (low returning divestment) or perceived (EPS dilutive) value?
- Potential earnings risk: Does the composition or structure of the balance sheet have the ability to positively or negatively impact earnings? Either in the short term via changes in costs such as higher interest expense, or the long term via changes in competitive positioning?
- Liquidity risk: Does the tenor of liabilities impact the ability to pay debts as they fall due? Does this create the potential for real value impacts?
- Solvency risk: Does the level of liabilities impact the residual value that exists in the company for shareholders?
Traditional quantitative screening models attempt to answer these questions using measures such as debt/equity or interest coverage. Whilst these are important, they are only part of the picture. In an age when financial data is ubiquitous, it is arguable that these simple measures can cause more harm than good because they miss both the nuance and the context of the calculation.
Within Blocks we have built our Template for the Balance Sheet Factor based on a two step process.
Existing Balance Sheet
The first step is to understand the current state of the balance sheet. This involves going beyond a simple net debt calculation to consider the entirety of on/off balance sheet items.
For example on the liabilities side:
- Are there other on balance sheet liabilities? For example leases, deferred consideration, provisions or other non-debt payables?
- Is net working capital positive or negative? What are the cash implications of a normalization of working capital?
- Are there off balance sheet liabilities? Either disclosed contingent liabilities such as court cases or financing bonds and guarantees or non-disclosed or quantified liabilities in the same vein.
- Are there contractual commitments (capex/take or pay contracts)?
- Are there operating cash outflows that will burn surplus cash?
And on the assets side some considerations are:
- Is the cash all available to shareholders (or required to meet regulatory or payable commitments?.
- Is the cash position representative of average cash balances over the period or just a period end measurement?
- Are there other assets that can be readily realised for cash (investments/assets held for sale), non-core property etc.
- Are there off balance sheet assets such as tax losses, franking credits or contingent court cases?
- Are the assets recorded at historic cost or current valuation?
- Are the assets recorded net or gross. E.g. Joint ventures record the equity value of asset, which may itself be highly leveraged.
Within Blocks you can review the existing state of the balance sheet using our Checklist Template: Balance Sheet Existing. Simply Navigate to the Templates section within the Process tab – click on Templates/Factors/Balance Sheet and copy the checklist into your personal library.
Balance Sheet Context
The second step is to understand the context of THIS balance sheet for THIS investment opportunity. What is a good balance sheet in one industry at one point in time may be a weak balance sheet in a different context.
- Is the current level of earnings sustainable? What looks like good interest cover for a cyclical stock in a strong economy can quickly deteriorate in a downturn.
- Are there off balance sheet liabilities or commitments that will chew up excess cash? Contractors in particular can be exposed if a fixed price contract goes bad.
- Are asset values and liabilities positively/negatively correlated? A geared balance sheet leading to forced asset sales will sell asset values fall as debt increases.
- How do balance sheet settings compare to current market cap? As the share price of a geared company falls, it can become more expensive as any capital raise to fix the balance sheet becomes more dilutive.
Within Blocks you can examine balance sheet context using our Checklist Template: Balance Sheet Context. . Simply Navigate to the Templates section within the Process tab – click on Templates/Factors/Balance Sheet and copy the checklist into your personal library.
Like all financial analysis questions, there are an infinite number of contextual wrinkles that can arise. No checklist will be perfect, but with experience you will start to anticipate risks and opportunities.
Follow us on Twitter to see some examples in action.