This is the fifth part of my 10 part series on the tenets of my investment philosophy. I believe that investing without a game plan is equivalent to a baseball player swinging with his eyes closed. Sometimes contact will be made, but not having a game plan makes the at bat that much harder. I’ve set up a Tenets of Investing page where you can click to check out all 10 of my tenets. And just to screw with you guys, I’m going to write about them in a random order.
Like my investing idols over at Contra The Heard, I spend a lot of time looking at the strength of the balance sheet for any of the companies I’m interested in investing in.
The reason is two fold. First of all, when I invest in a company that’s been beaten down, often profits have been beaten down as well. A company may be breaking even or losing money by the time it gets beaten down enough for me to have a look at it. If a company is in that situation, getting back to profitability is a much easier task than if the company has a bunch of debt it has to pay to service.
The other reason is if a company is in trouble and they have significant debt, refinancing that debt can become difficult. Nobody wants to lend money to a company that is having problems. If the company can find a way to refinance, often it’s at an inflated interest rate. Returning to previous form is much more difficult when debt service costs have gone though the roof.
If a company has a great balance sheet, generally that gives me the message that management is a more conservative bunch that shuns the idea of taking on a lot of debt to do something drastic, like acquiring a competitor. One of the biggest risks in buying shares in contrarian names is company specific. Anything that gives me assurance that the company is going to try to recover without taking on much debt is a good thing.
Much like on an individual’s balance sheet, debt takes away choices for a company. Perhaps a great opportunity comes up to buy a competitor selling for a great deal. If they have too much leverage on their balance sheet, they might not get the debt they need to make the acquisition. Costs to service debt can take away from research into new markets or products, making a company’s return to prominence much more difficult.
It’s quite often that an investor will find a company trading on an attractive basis from a book value perspective, yet that company will be carrying some debt. How much debt is too much debt? Should an investor shun companies completely that have debt?
There’s no easy answer to how much debt is too much. Depending on the industry, I’m tolerant of debt. A REIT will almost always have debt on the balance sheet. So will a utility or a bank. The key is to have a look at historical debt levels and the indebtedness of competitors. If the company’s debt to equity ratio greatly exceeds their competition, then maybe it’s a company to avoid.
Saying that, some of the best recoveries in recent memory have come from companies that seemed like they were drowning in debt. Teck Resources recovery from their low at below $5 to their recent highs of over $40 was remarkable in both its speed and the amount it returned to investors brave enough to buy when the future looked darkest. One may characterize that as speculating. Of course, one may also label contrarian investing as speculating as well.
I don’t hate debt. Companies need to borrow for all sorts of reasons. I just hate it in excess.