New Investment Guideline: Find Companies That Will Still Exist a Year from Now

Includes: DIA, QQQ, SPY
by: Graham Summers

Balance sheets are the new income statements.

Under Alan Greenspan’s easy money policies (1987-2006), Wall Street and most financial analysts became obsessed over earnings. Value investing—buying a company for less than it’s worth—was never a huge fad to begin with. And with the Fed’s credit faucet gushing liquidity, analysts became less and less concerned with what a company owned, instead focusing on how much it could earn and how quickly.

After all, if money was easy to come by, who cared about debt? You could always just borrow more to pay it off... or repackage your debt and sell it to someone else. “Buy growth and to hell with the balance sheet,” was the common mentality.

Nowhere was this more obvious than in valuation metrics. How often do you hear analysts or pundits referring to an investment trading for “less than book?” Instead, everyone and their mother raves about a company’s price relative to its earnings. Put another way, P/E ratios were king, while P/Bs were forgotten save for a few acolytes of value investing.

However, now that we’ve entered a period of credit contraction, deleveraging, and reduced consumer spending, earnings have taken a nosedive and balance sheets have come to the forefront of investment analysis. If you remove the $70 billion earned by oil producers in 4Q07 and 1Q08, profits at companies in the Standard & Poor’s 500 Index tumbled 26 percent and 30.2 percent, the biggest decreases for any quarter since Bloomberg started compiling data in 1998.

Earnings expectations, particularly at financial firms, have proven to be mirages time and time again. Combine this trend with the fact that everyone from auto-manufacturers to mortgage lenders has millions if not billions of junk assets on—or in some cases off—their balance sheets, and the question is not how much money a company will make, but just what exactly does it own?

Or will it even exist in a year?

Corporate profits can drop and companies still remain in business. Heck, entire industries—steel, airlines, etc—have multi-year long periods when profits are barely a trickle. However, if a company is sitting on billions in borrowed assets or finds itself on the wrong side of a margin call, then it’s highly possible that the company might cease to exist entirely.

GM knows that I’m talking about.

In today’s climate, investors are seeking safety above all else. This is why businesses with balance sheets that are both honest and transparent have become major targets for takeovers. Look at the Wrigley’s (NYSE:WWW) and Anheuser Busch (NYSE:BUD) deals. Neither of those companies were what you would call “growth” stocks. But you knew exactly what you were buying when you bought them. And so the buyers were willing to buy at a premium: 30 times operating earnings.

My suggestion to anyone looking for new investments right now is to look for businesses with honest and transparent balance sheets. You may not get a huge pop from better than expected earnings… but you won’t get the surprise of a bankruptcy or margin call either.

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