Let the Balance Sheet Be Your Guide

When looking at longer-term investment in a market like this, a healthy ratio of cash to debt will go a long way toward making your decisions easier.
Author:
Publish date:

The market just keeps getting worse. Every time we get one of those sharp ones- or two-day rallies, many of the talking heads and pundits immediately appear to declare that a bottom is in place. Each time, the selloff begins anew and drives prices down to test or create new lows. The tea leaf readers and technicians pore over their charts and tell us that there is now support at such and such level and we should bounce higher. We don't.

Others cite the fact that the market appears cheap on earnings and should go higher. Instead, earnings continue to drift lower, taking stock prices with them. Companies report earnings and proudly tell the world they lost less money than Wall Street expected. The stock goes higher and then resumes its downward path as investors realize that a loss is still a loss. Investing legends like Warren Buffet and Jeremy Grantham publicly declare that stocks are cheap, and still prices fall. It is easily the most difficult investing environment I have seen in my investing career.

We are not going to get any help from the economy anytime soon. Foreclosures are still climbing, creating downward pressure on housing prices. Businesses are cutting back production and inventories to prepare for a prolonged sales slump. The alphabet soup of programs from the Treasury have not slowed the losses or unlocked the credit markets for most borrowers.

What they have done is create a rush of large financial institutions buying small banks and declaring themselves to now either be a bank or a savings and loan and therefore eligible for access to the government balance sheet. Rather than use the funds for the intended purpose of making loans, the money obtained through the various programs is being used to buy other financial companies. This activity may work out very well down the road for the acquiring institution, but it does nothing for the financial markets or economy right now.

So, it's bad and we do not know when it will get better. In their public pronouncements, Mr. Buffet and Mr. Grantham both expressed a view that in the short run, the market may go lower until the economy improves. They were buying with a very long-term horizon. So should we.

I talk to people every day who are trying to bottom fish the stock market. They want to know if they should buy companies that are beaten down like Ford (F), General Motors (GM) or even AIG (AIG). Others wonder about buying the financials like Goldman Sachs (GS) or Citigroup (C ).

This is exactly the wrong approach in my opinion. I want to look for stocks that have a very high likelihood of surviving the downturn intact and will be able to fund operations and growth in the future.

How do we achieve this? First, I think we have to take a longer view as investors. First, avoid companies with debt. Not just those with a lot of debt or already known to be having trouble making their debt payments. I think the right thing to do is to avoid any company that has any debt right now. If you do not owe any money, it is impossible to get in trouble with your creditors.

Also, look for companies that have a lot of cash on the balance sheet. As we work through the problems in the economy and financial markets, there will be opportunities to buy distressed assets at bargain prices. Companies with cash will be in a unique position to create value through acquisitions and buy market share and earnings for a fraction of what it might otherwise cost. With credit markets tight, cash will be king.

The auto industry offers a good example of this strategy. The ongoing problems in Detroit have left the companies that supply the industry with falling sales and an uncertain future. It is not just the big three either. Worldwide the slowing economy has depressed sales and left suppliers struggling. Many of these companies have already filed bankruptcy, and more will follow.

Superior Industries

Superior Industries

(SUP) is not going to have this problem. They do not have any long-term debt. They also have a healthy cash hoard to get them through the disruptions in the industry. The manufacturer of aluminum and steel wheels will probably see the sales and profit declines of other suppliers to the industry. But the strong balance sheet will put them into a potion to survive and grow when market conditions improve.

The company has taken steps to improve the bottom line, switching production to lower-cost countries and eliminating excess capacity. Capital expenditures are declining as the company finishes the build-out of its Mexican production facility, and the savings will go right to the bottom line. They are having success with their ongoing efforts to diversify away from the U.S manufacturers.

Management is highly incentivized to succeed as well. The chairman of the company owns 15% of the stock. Why attempt to guess the future of Ford or General Motors and their debt-laden capital structures. If you want to invest in the future of the auto industry, Superior offers a way to do so through a company with no debt, 40% of the share price in cash and management as a partner. You also get paid to wait with the stock as it pays a generous 5.9% dividend yield.

KBR

I have written before about my expectations for the infrastructure stocks. Simply put, I think these companies will be the next group to experience a boom. They will lead the market higher when it does finally move off the lows. The worldwide needs in this area are just too great to ignore. The developed world needs to rebuild much of its infrastructure, and the developing world needs new construction to support their economies. There will also be global attempts to jump-start struggling economies with the Keynesian stimulus in the form of government spending on these projects.

KBR Incorporated (KBR)is a spinoff from Halliburton that is in a perfect position to profit. The company provides construction engineering and other services to governments and industries around the globe. The company's major customers are governments and oil companies right now, and this bodes well for their backlog. While some energy projects may be delayed while oil prices are down, the spending will get done eventually.

Company officials on a recent conference call told investors there had been no cancellations in their $15 billion backlog. In its recent third-quarter earnings release, the company announced that the backlog of business had grown 27% and revenue had climbed 39%. The balance sheet is rock solid. The company has no debt and over $1 billion in cash at the end of the third quarter. The cash represents about half of the stock price currently.

KBR trades at seven times earnings and less than three times enterprise value to EBITDA. This is a bargain price for a company that is growing in the current difficult economy and is positioned to be a major beneficiary of the need to spend on global infrastructure. The stock was a large holding of several hedge funds that have been forced to liquidate, and that selling appears to have created a cash-rich bargain.

One of the major advantages we have as individual investors are that we are not forced to do anything. We don't have to maintain a certain asset or industry allocation. We can simply ignore companies with debt-laden capital structures or those who will need outside financing to succeed. We can play areas where we expect rebounds, as with Superior, or strong future growth, such as KBR, with stock in companies that are self-financing and can take advantage of the opportunities that arise from the crisis.

Investing in this environment requires your time frame to be exceptionally long, and before making any purchase, you must reconcile that.

Companies that have little debt will be in a much better position than their rivals when the economy finally begins to turn around.

Having cash on hand is not only important to help get companies through lean times, but is an invaluable advantage when the economy begins to pick up speed.