Recently, I discussed my five “Must Haves” when digging into a stock for a long-term portfolio.
But now, I want to focus on a company’s fiscal health.
There is nothing more important than a strong balance sheet today.
It’s very easy to get wrapped up in momentum companies that have no financial data to support its stock price.
All you have to do is look at all the retail investors who piled into bankrupt companies on a whim – only to see their accounts implode in a matter of days.
I don’t want that to be you.
That’s why I want to go over a few simple techniques which will allow you to gauge a company’s health quickly and easily.
A strong balance sheet is not a static thing. It can change across industries and economic conditions.
J.P. Morgan (JPM) has something known as “a fortress balance sheet.”
It is one of the strongest banks in the world, and it is hard to imagine what could break them.
They sailed through the great financial crisis and have handled the pandemic well so far as well.
They have passed every test the regulators can imagine and merged with flying colours.
J.P. Morgan is leveraged about 10 to 1. In almost any other business EXCEPT BANKING, that would be a catastrophe waiting to happen.
The nature of banking makes that a conservative level. Before the Great Financial Crisis, banks levered up as much as 40 to 1 in some cases.
When famed investor Peter Lynch was buying shares of almost every bank and thrift in the United States back in the 70s and 80s, he thought anything less than 20 to 1 was pretty conservative.
Real Estate is another business where more debt is acceptable.
So are Utilities.
People pay rent and their power bills, creating lots of stable cash flows that can support a lot of debt.
Just be aware that things can change quickly.
Ask the people that used to run newspapers that used the same logic.
A Side By Side Comparison
Balance sheets need to be compared by industry, not against the broader market.
If you are looking at a bank, then the equity to asset ratio (equity /total assets) and the level of nonperforming assets are important.
The former needs to be increasing, and the latter should be decreasing.
The number 8 is the lowest equity to asset ratios you should consider.
Over ten is better.
Meanwhile, 2% is the highest level of non-performing assets you should consider acceptable when buying a bank stock. Anything higher than that is just a gamble that things get better someday.
At a REIT, I want to look at the interest coverage ratio.
Compare the Earnings-before-interest-and-taxes (EBIT) to interest payments.
Any result of less than 2 is a warning sign.
Nonperforming assets direction is also important.
You want to make sure that they are stable or flat.
Falling occupancy rates and declining rents are also potential warnings of credit problems ahead for a real estate investment trust. So, make sure to do a side-by-side of the numbers from this year compared to last year. It’s very important.
Z: The Most Important Letter in Finance
I want to avoid companies that are facing bankruptcy, not rush in with hard-earned money and throw away investment.
So, I want to know which companies to avoid before I make a wager on a turnaround or a bounceback. And when it comes to most nonfinancial stocks, I use a tool developed back in the 1960s.
Professor Edward Altman developed the Z-score to determine which companies might face the possibility of financial stress or bankruptcy in the next two years.
The Z-score uses a few balance sheet and income statement lines to make the equation.
Z-scores are widely available, so I will spare you the math.
A score of 2 or higher is good. A score of 3 or higher is well on the way to fantastic.
Watch the direction of scores as well. If you own a high score company and it begins to decline, it may be time to take a deeper dive into the cause of the decline.
You may decide to sell it and wait and see if the credit conditions improve for the company.
Lower scores are generally best avoided.
Companies with high average debt levels and low scores are probably headed for the dustbin of finance.
Companies that have high levels of debt, but high z-scores can be fantastic long-term opportunities.
If a high-debt, the high-score company is producing free cash flow and using it to pay down debt and buy back stock, you could be looking at a potential superstar stock.
I also think I need to be aware of what doesn’t work.
At first glance, companies with high cash balances and little to no debt would be VERY attractive.
All too often, however, these seemingly attractive balance sheet driven opportunities are money-losing companies that had a recent stock offering.
Many of these will be small biotech or technology companies with a lot of cash right now but are spending it at an alarming rate.
I don’t want to own those in a long-term portfolio.
Finding those few that have lots of cash, little debt and are generating even more cash is the stock market equivalent of Christmas.
That’s why each investment is worth a celebration.
I require a strong balance sheet for my long term holding because the best way to earn high long-term returns is for the company to survive for a long time.
I’ll explain a few other important ways to assess companies later this week.
For now, let’s enjoy the ongoing market rally and look for new opportunities as the COVID numbers decline.