Why balance sheet strength should interest investors more than ever
Our unswerving focus on balance sheet strength should stand us in good stead as the wider market’s reaction to the Covid-19 pandemic evolves beyond short-term profitability concerns
Balance sheet strength has always been a major focus for us, here on The Value Perspective. After all, when your whole investment strategy revolves around identifying businesses that trade at a significant discount to their intrinsic value, you want the stocks you do buy to be sufficiently robust financially they can survive periods of market turbulence – and so give the wider market the best possible chance to recognise their worth.
This point is so key to our process that one of our checklist of seven ‘Red’ questions we use to test the case for any potential investment asks how its balance sheet will stand up to stress. If it were possible, though, our focus has grown even stronger in recent years – not because we foresaw the arrival of a global pandemic but because we believed valuations were not compensating investors for taking increased levels of risk.
As contrarians, therefore, we concentrated still harder on balance sheet safety to ensure our portfolios were better protected than most from extreme levels of debt or leverage. This policy should now stand us in good stead as the wider market’s reaction to the pandemic evolves beyond short-term profitability concerns and towards distinguishing between companies with different levels of financial strength.
Having scrutinised and stress-tested company balance sheets through several economic and investment cycles, as we have here on The Value Perspective, we are keenly aware that financial risk is a moving target. So as soon as it became apparent how significant an impact this environment would have on company profits, the team set about re-reviewing all the companies in our portfolios to assess their balance-sheet strength.
The starting point for such an exercise is, unsurprisingly, a company’s balance sheet as it stands today. The market tends to concentrate on the ratio of a business’s net debt to its EBITDA (earnings before interest, taxes, depreciation and amortisation) but that is only the first – and perhaps the least important – of the various measures that can be used in this kind of analysis.
Just as a bank will have various routes to weigh up the state of your finances before deciding whether to offer you a mortgage, there are a number of ways of assessing whether a business can afford the debt it has. Where a bank might compare your monthly interest payments to your monthly salary, for example, with a company, we would look at annual interest paid versus its annual profits to ascertain its interest cover ratio.
A bank comparing your total mortgage amount with your annual income – that is, how many years’ worth of salary you are borrowing – would meanwhile be the equivalent in the corporate world to net debt to EBITDA. And then there is the loan-to-value ratio – how does your debt compare with the assets you are borrowed against? From a corporate perspective, this would be a leverage ratio comparing debt and equity.
Investors should make use of all these lenses when analysing a company’s balance sheet – although understanding the current picture will only take you so far. As we will see in our next article – How to stress-test a business’s finances – the hard work really begins once you start to think about how things could turn out for the company in the months and years ahead.
Fund Manager, Equity Value
I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.
Fund Manager, Equity Value
I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials. In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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