I’m sure many of you know all too well about the problem of insomnia. It affects four in 10 adults, according to the European Journal of Psychiatry. And a 2009 National Sleep Foundation study indicated that 67% of those surveyed experienced a sleeping problem at least a few days a week compared to only 13% in 1991.
I’m sure the wildly swinging stock market – down 50%, up 60% from the lows, etc. – hasn’t helped. Even as times get increasingly hectic, though, you want to make sure you’re getting enough quality sleep. It’s proven to help you function better during the day (and live longer).
The tie-in is that, when it comes to long-term investing at least, I’m here to help you sleep better at night. So today we’ll look at the importance of financial strength when searching for high-quality investment ideas.
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The Financial Fortress
To that end, my game plan is investing in Financial Fortresses – rock-solid companies that can withstand economic fallout (and occasional serious beat downs from Mr. Market. (Picture a Sherman tank that can withstand serious artillery attack.)
There are many high-quality companies in outstanding financial position because of the many reasons, including having a “very wide economic moat,” that I previously discussed.
From my perspective, a Financial Fortress is typically an investment-grade company that either has
a) a great balance sheet
b) large cash flow generating capabilities, and/or
c) impressive asset efficiency
To give you some idea of what I mean, here is a sample list of companies that are cash-rich or otherwise don’t carry any long-term debt.
View larger image here
Fiscal Prudence
Companies with great balance sheets have low long-term debt levels or even no debt at all (with actual net cash on their books). This creates a solid cushion, enabling such companies to weather tough economic times or temporary challenges to the underlying business. Operating with cash on hand and little or no debt also allows for tremendous financial, strategic and operational flexibility to fuel growth and generate solid shareholder returns. And for our purposes of protecting and creating wealth, a company with a superior financial position increases the odds of generating above-market returns.
Some companies are just very conservative and refuse to take on significant amounts of debt. Among corporate financial theorists, there is plenty of research and debate in regard to potential optimal levels of debt, equity and so on.
For many if not most companies, taking on a certain amount of debt makes sense. Companies can manage what is known as their “capital structure” by issuing debt or raising new funds through equity offerings (issuing more stock) during a strong market period. Or, companies can be so profitable that they generate ample “free cash flow” from their day-to-day operations.
Regarding dividends, I want more than a company that is earning enough to safely cover its dividend commitments. Something that is called the “payout ratio” is a great measure of a company’s ability to pay its dividend (based on cash and earnings trends.) If times get tough, I want to feel safe about a company’s ability to pay its dividend. As we’ve seen in the past year, it is usually treacherous for the stock price when a company has to cut its dividend unexpectedly.
Cash (Flow) Is King
As mentioned, a Financial Fortress type company may generate significant amounts of free cash flow from operations. Free cash flow is generated by businesses’ ongoing operations after taking into account taxes, interest expense, and amortization.
Companies with actual “net” cash balances, where their cash and short-term cash equivalent assets on hand exceed total levels of debt, can be very attractive. Think of companies that have so much cash sitting on their books, and are generating even more cash at such a rapid pace, that management can’t deploy it fast enough. Many of the best-run companies generate huge cash flows from their businesses.
Importantly, you also need to have a strong management team making shareholder-friendly decisions with that cash. This could mean things like making great acquisitions... reinvesting back into the business... stepping up research and development... or even returning it to shareholders (i.e. through dividends).
Asset Efficiency
Regarding an important metric known as asset efficiency, there are several potential factors to consider. Important measures like return on assets, return on equity and inventory turnover should all be impressive. Working capital efficiency is also very important, in terms of looking at current assets and liabilities.
So how do you know if the ratios you’re looking at are good or bad? Here’s the key. It’s hard to figure out a company’s position just looking at ratios at one point in time, or in isolation from other factors. The company’s financial ratios should be examined both relative to past levels and relative to its industry peers. Analyzing these ratios alongside competitors’ ratios over time can give a good sense of a company’s strength and how it is trending.
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Struggling Companies Can Be Profitable…
Now, there are plenty of opportunities to make money off of lower-quality stocks too – those that are highly leveraged (carrying lots debt), struggling to make interest payments, or fighting to survive in a tough industry. A lot of those opportunities can be shorter-term cyclical-type trades (as opposed to true long-term investments).
Think about how much money was made in Ford Motor Company (F:NYSE) when everyone thought it was going bankrupt, as the company was burning through its cash balances and losing money instead of making money. Well, if you had the stomach and skills to believe it would turn around, you would have done incredibly well. In one year, the stock went from under $1.50 to over $9 today!
There is a segment of successful investors that looks for these companies first and foremost, either as turnaround or takeover candidates or failure candidates to bet against (go short). Regardless, though, this “distressed” type of investing can be very challenging, with a lot of risk to go along with the potential for high returns. It isn’t the type of game that allows one to sleep at night.
…But Quality Is Better for Sleep
Turning back to Financial Fortress companies, they’re a better way to ensure wealth preservation, in my view, because they are less likely to disappoint and are always focused on creating and protecting shareholder value.
Many great companies tend to be conservative in their capital structure and their use of cash (but not in their desire to grow profits). If they don’t have opportunities that can grow the business and its overall profits, then the best management teams understand it is important to give that cash back to shareholders (in the form of dividends). Investing in these high-quality, rock-solid, Financial Fortress type companies lets us feel confident that our precious savings and retirement dollars are safe and growing.
Great Returns and Great Times,
Kent Lucas
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