Sent: 10-05-2011 10:43:04
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Balance Sheets are History
A strong balance sheet is supposed to be good but it might not say anything about the financial or investment prospects of a company.
Fund managers often talk about using a strong balance sheet as one of the criteria in choosing an investment. A little like motherhood, the importance of balance sheet strength is little questioned.
Balance sheet strength comes principally from some combination of:
- retained capital;
- large cash balances or low debt; and,
- previously purchased assets.
Let's say Company A raises $100 million and buys an income producing asset for $80 million that requires $5 million in annual sustaining investment and generates $10 million in EBITDA. Company B borrows $80 million at 6% to buy the same income producing asset for the same profit outcome.
By conventional standards, Company A has the stronger balance sheet. But which company is the better investment?
A good deal of conventional wisdom says the first because it would have a relatively large annual surplus for shareholders. In the second case, the surplus available for shareholders would be one tenth of what it would be for the shareholders of company A.
In this instance, however, shareholders invested in company B are going to get an infinite return on their investments. The shareholders in the Company A, on the other hand, will receive a lower return than the financiers of Company B with considerably more risk.
Yet, if the first investment filter to be applied was "balance sheet strength", company A would come out on top as the investment choice.
The investment attractiveness of a company depends not so much on the size of its balance sheet as on how the balance sheet is used to effect a return for its shareholders.
From a practical standpoint, a strong balance sheet might make it easier to raise capital. BHP Billiton, for example, can command more financial firepower than a company capitalized at, say, $100 million. But if BHP Billiton is simply going to use this financial strength to buy an asset worth $40 billion for $40 billion, as in the failed Potash Corp deal, the benefit of the large balance sheet is unclear.
Large balance sheets imply an historical accumulation of assets and nothing necessarily about future investment returns.
The choice between companies like A and B arises frequently in the context of resource sector investing. Equivalents to Company B are continually raising relatively small amounts of equity capital to push ahead with often disproportionately large projects.
Sundance Resources is probably best known for losing its entire board of directors in a plane crash in 2010. However, it is developing two iron ore mines in west Africa with a likely capital cost around US$4.5 billion, an amount which dwarfs its current balance sheet which, after a $60 million capital raising last month, will have net assets of approximately$ 224 million.
In the resources sector, companies aim to develop mining projects with as much debt as possible so as to maximize the return to equity holders. Companies manage to do this to varying degrees. Some, admittedly, are entirely unsuccessful. However, the attractiveness of the investments bears little relationship to the strength of the company's balance sheet.
These points are not confined to resources companies. Microsoft has a very strong balance sheet. At the end of March, it had net cash reserves of US$50.2 billion and net equity of US$99.7 billion. Its balance sheet is very much a product of a history of groundbreaking innovation. Any investor would have loved the 19% per annum appreciation in its share price since 1990. But the share price since 2001 has returned zero while Apple Inc, for example, has delivered a 3,700% rise.
The challenge for Microsoft, notwithstanding its history, is to come up with enough new ideas on a sufficiently large scale to provide an adequate return on the funds it is holding.
Similar examples can be found in the pharmaceutical industry. Merck, for example, has a strong balance sheet - $12.2 billion in cash, $17.8 billion in debt and $54 billion in shareholder equity - but its fortunes depend increasingly on four influences:
- the quantity of historically developed drugs coming off patent;
- its ability to discover new drugs with mass appeal;
- the pressures from governments to make drugs cheaper; and,
- demands from shareholders to cut research spending in favour of dividends.
The Merck balance sheet is good to have but is reflective of a history which is the mirror image of the era it is entering. Not surprisingly, its share price has been declining at an average annual rate of 5.5% for the last ten years.
This is not to say that the size of a balance sheet is entirely irrelevant. However, equity investment products that start with the balance sheet are saying "buy history".
An investment product that lines up everything else and then uses balance sheet strength as a final differentiating feature is more likely to get the choice right because it recognizes that future cash flows (and capital minimization) generate value and that balance sheets are largely about historical outcomes.
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