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Why you should, frankly, give a dam about company balance sheets

When we analyse a business, we want to ensure it is as much protected from bad news as is possible – in effect that its balance sheet is able to act as a dam against inevitable periods of market turbulence

12/02/2019

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Far be it from us to take issue with Warren Buffett but while the Sage of Omaha is famously fond of identifying companies that are like castles surrounded by “economic moats”, here on The Value Perspective, we are more interested in businesses that enjoy a different sort of water-oriented protection – a dam.

A sustainable advantage 

When Buffett refers to a business having a moat, he is talking about a sustainable advantage over its rivals.

That could, for example, be pricing power, barriers to entry or some kind of intellectual property but the point is that the moat serves to prevent the marauding forces of competition from overwhelming the business – and it needs to keep on doing so.

Buffett has said he has one message for the managers of businesses he owns – “Widen the moat” – adding: “And we want to throw crocodiles and sharks and everything else, gators, I guess, into the moat to keep away competitors. And that comes about through service, it comes about through quality of product, it comes about through cost, it comes about sometimes through patents, it comes about through real estate location.”

It goes without saying Buffett knows what he is talking about and has the long-term performance record to more than back up any analogy he cares to use.

That said, here on The Value Perspective, we prefer not to think in terms of moats on the basis that, with enough ‘firepower’ – enough cash thrown at it, say, or enough competitors attacking it – few moats are wide enough to protect a company indefinitely.

At this point, it is also worth noting there are few investors with Buffett’s expertise at appraising moats – and significantly more who invoke his terminology and see moats in every (currently) high-performing company they analyse …

Here at The Value Perspective, however, out stance is very much ‘safety first’, which means working hard to ensure any business we do own is as protected from bad news as possible.

Dams, not moats

 

So, rather than moats, which are focused on maintaining strength, we like to think in terms of dams, which are designed to protect from the worst – though we admit the analogy was not fully formed in our minds until we saw the following photo of how one enterprising farmer protected his homestead as the Mississippi reached a record high in 2011 and flooded the surrounding area.

  

In our comparison, the dam equates to a company’s balance sheet strength – and the better the quality, the higher the ‘dam’ and the more able the company is to protect itself when the metaphorical competitive or economic heavens open. 

When the rains come – as they inevitably will for any business, even if nobody can forecast precisely when – we want to make sure the companies we own are suitably protected.

The height of a company’s dam will change each year based on both its economic performance and the capital allocation decisions made by management.

Cash generated by the company is piled on top of the dam increasing its height, for example, while an uncovered dividend will reduce its height.

The worst possible capital allocation decision – an expensive acquisition – can meanwhile flatten a dam and leave a company totally unprotected against even a slight change in the economic weather.

All of which means, here on The Value Perspective, we spend a lot of our time measuring and testing the balance sheet ‘dams’ constructed by all the businesses we analyse, and how they have changed over time.

In doing so, we are striving to ensure the companies we invest in have the best chance of surviving extended periods of market-related turbulence – even if their competitors end up being washed away.

Author

Kevin Murphy

Kevin Murphy

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.

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