On Financial Strength
Although I have previously discussed companies with heavy debt loads (e.g., Energizer), I generally seek to buy shares in companies of unquestionable financial strength. I agree with Marty Whitman, who wrote in his book The Aggressive Conservative Investor that a strong financial position has more to do with the absence of liabilities than with the presence of assets. Businesses with substantial future obligations, whether these obligations are stated on the balance sheet or not, often prove to be disappointing investments.
An absence of liabilities is not merely a safeguard against insolvency. A strong financial position is a first class asset. It allows a company to borrow when money is cheap, rather than when money is needed. Even more importantly, it encourages long – term thinking. There are times when big investments in the future are required. A financially sound firm is in the best position to make such investments.
One of the greatest benefits of a strong financial position is the protection it affords the common stock holder. Countless times, I have mentioned the damage done to shareholders by new equity and debt financing. New equity dilutes; while new debt imperils.
Growth is an important part of the value equation. But, it only counts insofar as the shareholder reaps the rewards. No owner benefits on the basis of total revenues; each benefits to the extent of the profits attributable to his share of the business. Siphoning profits off to creditors or divvying them up among new owners effectively destroys that growth.
Buying stocks when they trade at low earnings multiples does help minimize an investor’s downside risk. But, that isn’t the only way to minimize risk. The future is always uncertain. There are a few companies who possess such wide moats that an investor can largely confine his analysis to the earnings record. He can feel secure in his belief that thirty years from now the business will remain much as it is today. But, these companies are few and far between. Mr. Market rarely offers them at bargain prices.
A strong financial position offers a kind of freedom. It also acts as a safeguard against uncertainty. If an investor buys stock in a company with a strong financial position when it is trading at low price – to – earnings, price – to – sales, and price – to – book ratios, he will greatly limit his risk.
Companies that are both highly profitable and relatively unencumbered can prove to be spectacular investment opportunities, even when the industry in which they operate faces great uncertainty. It is not unreasonable to expect that a financially sound firm generating large amounts of free cash flow will eventually find a way to productively use those cash flows.
A financially sound firm has the luxury of time. It can play the nimble competitor. A highly encumbered business faces greater risks in a period of upheaval.
Insolvency is not the only threat. Often, a highly leveraged company will be able to pay its bills, but will be unable to make an adequate investment in the future. Eventually, every business will make mistakes. Isn’t it best to put your money where those mistakes are likely to be the least costly?
The greatest liability is usually the one that does not appear on the balance sheet. Nothing destroys shareholder wealth faster than the expenditures necessary to stay competitive. These requirements may come in the form of capital expenditures, or advertising, or research, or a hundred other things specific to the industry.
Some businesses only acquire new customers at great cost. When analyzing such businesses, it is unreasonable to expect advertising expenses to ever abate. They are a necessary and permanent part of the business. The brand must be maintained just like the equipment on the factory floor. These businesses are as unattractive as the old manufacturing companies who must pour ever greater amounts of capital into ever outdated plants.
The best business is usually the one that costs the least to maintain. Such a business offers the greatest rewards and the least risk, provided it is purchased at a bargain price.