Case Study: The Importance of Good Balance Sheets
This is Part 4 of A Portfolio For Mom, which explores the portfolio we're building for one of our most important clients. The series outlines our investment philosophy, centered on loss avoidance, while hopefully educating our client through a variety of case studies.
We'll introduce the philosophy, present case studies, and discuss potential stock candidates. With the help of the Seeking Alpha community, we hope to improve her investment returns.
Part 3 highlighted five businesses with great balance sheets -- in fact, they all had net cash. In this edition we'll discuss the perils of owning a business with a lot of debt and why we want to avoid these risks in A Portfolio For Mom.
Good Financial Health
Warren Buffett once said about debt: "If you're smart, you don't need it; if you're dumb, you shouldn't be using it."
This is why owning businesses with good financial health is so important to successfully building wealth over time. You manage your finances prudently and you should expect the businesses you own will manage their finances prudently as well.
Good financial health starts with a good financial history. We want to see that a company has operated profitably for many years in a row, especially during recessions. We want to see that it pays back any money it borrows. We want to see that it spends money wisely and respects shareholders.
Most importantly we want to see that it doesn't borrow too much money and expose shareholders (i.e., us and Mom) to excessive financial risk. Across a diversified portfolio, we think that further lowers Mom's risk and improves her odds of building wealth.
The Problem with Debt
Debt is a simple thing to overlook when investing. When things are going well, it isn't a problem (and you rarely hear it discussed in the financial media). It is in scenarios where something goes awry that debt becomes a problem.
Owning a business with a lot of debt is like playing with fire; own it long enough and you could get burned. In our case, we want to keep Mom away from the fire altogether.
Let's explore a popular topic as of late -- oil companies.
Too much debt at a company that is exposed to the wild swings in the oil price proved to be an investor's worst nightmare. Oil might be the farthest thing from the simple, unexciting industries we're looking for.
To illustrate, let's look at a large Canadian oil company, Cenovus Energy (NYSE:CVE).
At $100 a barrel, Cenovus did not have a debt problem; (they did have a spending problem though). When the oil price declined, profits fell and debt became a burden. In order to meet their interest and spending obligations, they were forced to reduce the dividend.
Who suffered from their irresponsibility? Shareholders who saw their dividends reduced. Oil companies with good dividend yields were among the biggest illusions of security in the last decade. You could swap Cenovus with Crescent Point (NYSE:CPG) (or most oil or mining companies for that matter) and the results are unfortunately very similar.
In contrast let's look at another business with cyclical exposure to the economy: Richelieu Hardware (OTCMKTS:RHUHF).
Even when the Canadian economy was in a recession, sales at Richelieu declined only 4%. Once the economy emerged from recession, sales began to grow again and so did the dividend. Even today as the economy slows, the dividend isn't at risk; in fact they've continued to increase it because the financial health of the company is good.
The future for Richelieu may certainly be different from the past (i.e. something may go awry) but we think its good balance sheet lowers the odds of realizing a significant loss going forward. These are the types of situations we want to invest in.
Sure, if oil rebounds Richelieu won't return as much as Cenovus. But that isn't our primary objective. Remember, we first want to avoid losses and sleep well at night -- in other words, lower risk. If we focus on that along with quality, profitable companies, we think the upside for Mom will take care of itself.
Up next is Part 5, which will introduce the next five candidates for A Portfolio For Mom in line with our portfolio philosophy of loss avoidance, reliable profits and financial health.
What do you think about owning companies with minimal debt? How much of a priority is it in your research process? Do you own an oil company that cut its dividend? Are we missing any key points to help Mom understand the importance of good financial health?
Disclosure: I am/we are long RHUHF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.