Is Balance Sheet Investing Dead?
A lesson from Ben Graham's Security Analysis
"That's one thing we've never talked about here, but I spend more time looking at balance sheets than I do income statements... There are things that are harder to hide or play games with on the balance sheet."
("Wall Street tends to do the opposite") - Buffett
I'm currently reading Part 6 of Security Analysis, where Graham thoroughly goes over how important it is to look at the book value of a business because:
It tells you how much capital is invested in it - how many dollars you're paying per $ of capital investment
Shows you the capital structure - (complicated? share trend, securities outstanding and seniority (costs), etc)
Estimate of liquidation value (margin of safety?)
% of assets that are intangible, especially goodwill.
Write downs? Did they do this once to fuel future earnings?
And so on.
Graham already says in 1940 that people stopped looking at balance sheets to focus on income accounts. Management can lie everywhere, but it's way easier to do so in income statements. Just assume a new method for inventory or d&a, recognize sales that haven't occurred, capitalize expenses instead of including them in g&a, and you self-manufacture high margins.
The accounting department can become a great profit center.
Balance sheets show you a business's history. They show buried mistakes. How long have receivables been outstanding? Are they really current assets? Did they overbook sales? Are they recording bargains on m&a or always paying in excess of book value? how much in leases till end of contract? is net ppe stable (capex cancels out depreciation)?
Sure, new economy companies live on intangibles, outsource manufacturing/production, and ROICs are as fat as they've ever been. But is growth coming at the expense of dilution? What is that growth worth if a dominant position is likely to be lost?
Sometimes, instead of just looking at headline numbers, you can look at the balance sheet and find out that a business might be trading at:
Mkt cap of $40M and EV of $50M ($10M net debt).
But the business has $25M in highly-likely-to-collect-receivables. Maybe total current assets of $50M with total liabilities of $25M. How much does the price you're paying for the business change after just one glance?
It’s true that there are not as many companies trading below liquidation value as there were 70 years ago. The more businesses I research, the more I think a margin of safety is mainly derived from a deep balance sheet analysis rather than some vaguely guessed continuation of the earnings trend.
Ignoring the balance sheet is the result of decades of focusing on business quality and leaving the price question aside. Book values don’t mean much in the digital economy, and most coverage is fully focused thereon. Old economy industries and business models were left behind by the media. Those that actually require CapEx to grow or hiring more people to increase their customer base.
Antique investment principles still apply, and there’s no reason why these businesses wouldn’t do well in the future. On average, I’m inclined to suspect that this is where purchases with a margin of safety can be found.
Just some thoughts. Hope they triggered more.
Best, Giuliano
giulianomana@0to1stockmarket.com