The job of a professional investor is as much about avoiding disasters as it is about picking winners. Most fund managers can select their share of winners, but what will often differentiate a good portfolio manager from an average one is holding fewer losers than the competitors.
In analysing my worst mistakes over the years, I have identified three recurring factors. They are: poor balance sheets, poor business models and poor managements. Of these three, by far the most common cause of grief has been the poor balance sheet.
Take four of the worst performing stocks in the Fidelity Special Situations fund over the last year or so of my management: Isoft, Scottish Media Group, Erinaceous and Johnson Services Group. All had weak balance sheets. Fortunately none was a big position.
What do I mean by a weak balance sheet? Normally, you’ll find a weak balance sheet in a company with significant bank debt or bonds on its books whose value is high relative to the company’s net worth or cash flow. Debt can take other forms. Pension fund deficits, redeemable preference shares or future liabilities can all be sources of balance sheet weakness.
In itself, debt is no bad thing. It has the potential to increase returns for equity holders, but it also increases the risks. Buying a company with a lot of debt on its balance sheet is, in many ways, similar to buying the shares of a financially strong company but doing so partially with borrowed money. These shares have high upside if things go well, but the reverse if they don’t.
This contrasts with one of my favourite categories of shares, which are those with limited downside but also reasonable upside. These “skewed” return companies are ones where you shouldn’t lose too much money and you might just do very well. Often the characteristic that limits the downside is a strong balance sheet with significant net cash or liquid assets.
When looking at companies with weak balance sheets, watch out for the date at which the debt levels are recorded. This can be misleading in companies whose debt level is subject to seasonal variations, whether during the month, quarter or year. In this case, looking at the absolute debt level at the half year or year-end may give a false impression of strength.
A few tips here: it is well worth looking at the net interest figure as well as the debt as this can give an indication that average debt levels are higher. One of the questions we ask such companies is what their average debt levels are, which is not something normally reported.
Most companies consume cash as they grow and release cash as they shrink, so a sign that a firm is expanding too quickly can spell danger, while those shrinking are often safer, though there are some important exceptions. For example, many contractors which have customer advances against future work consume cash if they shrink.
Investors can do their own calculations of a company’s financial strength by studying the balance sheet, profit and loss statement and cash flow statement. But there are also some shorthand ways of finding out how robust an organisation it is.
The most commonly used method is a ratio called a “Z” score. It’s based on the financial characteristics of companies that have got into difficulties in the past (such as receiverships or needing to raise more equity). The analysis shows which financial ratios were the best predictors of their performance. These particular ratios are blended into a single ratio of financial strength called a “Z” score.
The companies in the weakest quartile of scores in their sector are the ones on which to keep a special eye, especially if the score is in the lowest decile.
I am not saying that an investor should never buy companies with weak balance sheets, but they should only do so with their eyes open to the risks involved and pay special attention to their progress. If something starts to go wrong, these are the holdings that should be sold early, even at a loss.
Highly geared companies are particularly exposed if business conditions change for the worse. In my portfolios I have always watched particularly closely companies in the weakest quartile. It is also one of the key inputs in my decision of how big a position I would want to take in a company.
If it has a weak balance sheet, other things being equal, I would normally buy a smaller position than in another equally attractive company that had a strong balance sheet.
I am always surprised how little analysis of balance sheets is done by most equity analysts at investment banks and brokers.
Often I will read a report on a company I know to have a pretty weak balance sheet and no reference will be made to this at all. I think most investors could gain from a better understanding of the risks they are taking when they buy shares of companies that have weak balance sheets.
Anthony Bolton’s Fidelity Special Situations fund has been the top performer in its sector since its launch in 1979. He was manager of the fund for more than 27 years and now mentors Fidelity’s managers and analysts.
The Anthony Bolton Column appears in FT Money on the first Saturday of alternate months: March 1, May 3, July 5, September 6, November 1, January 3
2009
