Over the week past the Lunar New Year, I was deeply immersed in the field of professional money management.
Not literally of course, but through literature.
I had perused several books written by seasoned fund managers, who possess more than a century's worth of successful investment experience in the stock market combined.
One of these books is titled, "
Common Stocks & Common Sense - The Strategies, Analyses, Decisions and Emotions of a Particularly Successful Value Investor".
The author is Edgar Wachenheim III, founder, CEO and chairman of Greenhaven Associates, a value-based equity hedge fund with US$9.38 billion AUM. From 1988 to 2017, Wachenheim had generated an average annual return of roughly 19 percent before fees for Greenhaven clients [source:
CNBC].
This is no small feat, considering the graveyard of finance is littered with tens of thousands of failed hedge funds. When an accomplished investor is willing to share his life experience in a book, one has to naturally pay attention to the lessons.
Indeed, it was an eye-opener as Wachenheim described his thought process on several of his investments, and preached the wisdom gained.
Here is one memorable quote from the book:
A shareholder makes money off the income statement, but survives off the balance sheet.
What Wachnheim means is that for an investor to know whether a company is rewarding, look at its income statement; but to know whether a company is risky, look at its balance sheet.
I wholeheartedly agree.
Investment outcomes are probabilistic in nature. The extent of a gain/loss exists across a spectrum. As investors, our foremost concern should be to minimize the left-tail risk of permanent loss in our capital.
Recall Warren Buffett's two rules: Number 1. Don't lose money; Number 2. Don't forget the first rule.
One of the best ways not to lose money is to NEVER invest in companies that have trouble operating as a going concern. These are businesses leveraged to the hilt, but have no sustainable way forward to repay the debt, as well as companies stuck in a sunset industry and generating waning cash flows. They are the "dying embers" of the corporate world - one last flicker before the flame goes out.
Examples are plenty. Think automobile manufacturer General Motors, before it went belly up in 2009. Think local water treatment firm Hyflux, before it filed for bankruptcy in 2018. Or the 56 companies currently suspended from trading on the Singapore Exchange.
Shareholders of such firms face dim prospects of recovering their money.
While it may be tough to identify companies whose management are engaged in hidden, unscrupulous activities, the telltale signs of a fundamentally unsound enterprise are often visible in the balance sheet.
Granted, going through a balance sheet can be daunting for the layman investor. If reading stacks of tiny digits makes your head spin and want to give up, allow me to point you to the three numbers on the balance sheet that I pay the most attention when researching on a company.
The first number is
Total Liabilities, which indicates the overall financial obligations of the company as at a specific date.
These include borrowings (from banks and the debt market), undelivered goods and services, as well as all things payable (capitalised expenses, mortgages, money owed to suppliers etc).
Total liabilities can be subdivided into current and non-current (or 'long-term') liabilities. Current liabilities are payable within one year. Non-current liabilities are due after one year. Regardless, they represent monetary burdens that must be resolved at a future point in time.
Here is an example from the most recent filing of a local listed company (let me call it Company X):
As seen above, Company X has a total liabilities of US$29.65 million as at 31 Dec 2023. Keep this figure in mind as we explore the next number.
The second number is
Cash and Cash Equivalents. Cash is self-evident. The 'cash equivalents' here refers to highly liquid instruments that can be easily converted to money. These include money market securities, banker's acceptances and even short-term government bonds.
This figure sits in the Assets section and is usually the first item on the balance sheet. The position of this number at the very top speaks volumes of its importance.
As seen above, Company X has cash and cash equivalents of US$52.05 million as at 31 Dec 2023.
If we compare the first and second numbers, we can see that Company X is more than capable of repaying its total liabilities using its cash coffer. (As for why Company X is keeping so much cash and not returning a portion of it to its shareholders, this is a different discussion altogether.)
The third number to take note is
Total Equity. This item is found below Total Liabilities and comprises shareholders capital, treasury shares, reserves and retained earnings/losses from previous fiscal years.
Think of total equity as the money left after selling all assets to repay all liabilities of the company. You wouldn't want this number to be negative. If it is, the company is in serious trouble. I would suggest to give it a miss.
As seen above, Company X has a total equity of US$56.38 million as at 31 Dec 2023. It doesn't look bad at all, but notice Company X has accumulated
losses that is nearly as big as its total liabilities. One wonders what the heck the management has been doing to the business all these years.
Based on these three numbers, we can compare the company versus its peers and against history. Throw in net income from the income statement and we can work out a slew of ratios such as the return on capital etc. These metrics should give you an approximate idea on whether this company is relatively healthy and capital efficient, or not.
A full study of the balance sheet is beyond the scope of a mere blog post. If you are keen, a decent accountancy textbook should help.
There are other interesting aspects of the balance sheet that warrant further elaboration. (Footnotes, anyone?) However, I hope this basic introduction has made the balance sheet a little less intimidating for you.
Here's to your survival (and prosperity) as a fellow risk-conscious shareholder.
