Earlier, I wrote an article about a couple of red flags that investors should keep their eyes out for when looking for the best ways to deploy their money. In this article, we'll go over a couple more - excessive leverage and hidden balance sheet problems.
Excessive leverage
Debt is a tricky thing. On one hand, companies that can afford to borrow money at low rates and reinvest it efficiently should do so. On the other hand, excessive leverage has been the demise of many an overreaching management team. In my experience, the debt-to-equity ratio is a good rough measure of how leveraged a business is.
Debt can be used to grow revenues and earnings, and ideally it will do both of those things. However, the problem with leverage is that it magnifies your losses as well as your wins, so if a business’s borrowing costs exceed its income, problems can quickly start to pile up. A high debt-to-equity ratio can help you identify businesses which have the potential for such problems.
One caveat I should add is that different industries will have different average debt-to-equity ratios. As a rule of thumb, the more capital-intensive the sector, the higher the average debt-to-equity ratio will be, so an oil and gas distribution company will tend to have a higher debt-to-equity ratio than a software company.
Hidden balance sheet problems
Accounting is weird. In an ideal world, the standardized set of financial statements that all publicly traded businesses are required to publish, i.e. the balance sheet, earnings statement and statement of cash flows, would be enough to understand any company. In reality, management teams will often hide things in the appendices and notes that accompany their disclosures, knowing that most people don’t have the energy or desire to read the small print.
In general, the more arcane and confusing the disclosures are, the higher the likelihood that management is trying to hide something. There’s an excellent Warren Buffett (Trades, Portfolio) quote from the 1995 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) annual shareholder meeting that summarises this idea very nicely:
“When the accounting confuses you, I would forget about it as a company. It may well be intentional, and in any event you don’t want to go near it. We have never had any great investment results from a company whose accounting we regarded as suspect. It’s a very bad sign. Accounting can offer you a lot of insight into the character of management.”
In other words, "creative" accounting is a warning sign in and of itself, and can help you whittle down the set of companies that you are considering investing in. There are almost 4,000 publicly traded companies in the United States - why would you waste your time with the ones that aren’t honest with their shareholders?
Disclosure: The author owns no stocks mentioned.
Read more here:
- The Value Investor's Handbook: Two Warning Signs to Look Out For
- Bill Ackman: How to Invest in Technology Companies
- Jim Chanos Updates His Tesla Thesis
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