All investors are exposed to risk when investing in any form of asset class, be it equities, bonds or property. Risk is not this unknowable, esotheric concept that so many amongst us fail to recognise. Risk, according to Warren Buffet, really is defined as the probability of a permanent loss of capital. And taking a lesson from the world’s greatest investor, I would think it unwise to define risk in any another manner. Perhaps, an example at this point would suffice to drive home a message on risk.
Company A & Company B
Let us focus on a thought experiment for a moment here. There are 2 companies, Company A and Company B. Company A has little to no debt . Company B however is a highly indebted company with a debt to equity value of more than 200%, decreasing revenue and operating income as a ratio to interest expense has deteriorated in the last couple of years . Company A has a price to book value of 0.7 while Company B has a price to book value of approximately 0.6 as well.
Would you buy Company A or B at this point? Now, bear in mind that Company B gives dividends while Company A also gives dividends. So which company would you buy? So on a dividend basis, let’s take it that both companies differ only slightly and these differences are negligible. Since this is a thought experiment, let us simplify things that way.
Maybe one might reason at this point that Company B seems cheaper. On a price to book basis, many might opt to buy Company B. Now the thing in the stock market is that, sometimes, “cheap” occurs for a reason and as investors, we would have to try our utmost best to figure out why it is cheap and frame it in the context of the risk involved.
Since we define risk to be the probability of permanent capital loss, Company B would be a company to be wary of as its debt to equity is incredibly high at a ratio of greater than 2. While debt is not a bad thing all the time, depending on the part of the business cycle the company is operating in, high levels of debt may do a company in when revenues in the company shrink. That is, it may cause bankruptcy.
Going back to the question before, which company would you buy? Some might say they would buy Company B while some might say they would buy Company A. And some, would be understandably undecided. Fair enough. Perhaps there is not enough information here.
Company B’s fortunes are susceptible indirectly to the price of oil, a commodity whose price has been on a downtrend since 2014. Company A may be of some interest to readers here. It operates without debt and is largely profitable. However, Company B weighs heavily on the minds of many investors who have been bitten recently as it announced that it would place itself under judicial management. The signs were all there but investors failed to see it, falling for what their bankers sold them on. The name of the company is Swiber Holdings Ltd. Read more about our mini case study on Swiber.
Price Chart Of Swiber Holdings
Source : FT Markets
If given the choice, maybe quite a number would have been suckered into buying Company B on a price to book basis. Simplistic reasoning going in the form of “If they give dividends, they must be sound!” echo through the market. “It gives dividends!”Giving dividends is really not the be all and end all in terms of the financial strength of the company. It only tells the investor that the management is willing to reward shareholders. But at what expense? Shareholders weren’t the only ones that were duped. Bond investors also are faced with the possibility of a permanent loss of capital when things turn bad.
So back to the idea on the permanent loss of capital. If you had to choose which would you choose? Company A or Company B. Be honest with yourself now. What you read in the papers are just headlines. However, the financial statements of the company paint a picture worth a thousand words before, as they say, sh** hits the fan. So Company B, faced with falling revenues, increasing indebtedness in the midst of falling oil prices is faced with the prospect of winding up.
Also, note one thing. A low price to book value or a large discount to net asset value does not mean that there is a margin of safety. As you can see from the example above, a company with a low price to book value may still be a candidate for a permanent loss of capital.
Now if I had to choose, I would choose Company A but if if I didn’t have to choose, I would probably ask for more information on Company A. Company B on the other hand posed a greater risk in the form of a growing probability of a permanent loss in capital. So much for the semantics, all I am trying to say is that you could really lose your pants as a bond investor or a share investor in Company B.
So permanent loss of capital surely is something to think about for aspiring investors. And for me personally, to prevent that, one has to do balance sheet analysis and really ignore the exciting stuff. We are not really talking about growth or market share or earnings per share projections here. All those are really secondary. The meat is in the balance sheet. If you want to know if a company can survive a high stress event, it is important to look at the balance sheet to get a sense of the financial strength of the company. I mean, why would you concern yourself with market share and/or earnings per share projections if the company may not be able to meet interest payments on its debt the very next quarter? Some food for thought maybe.
What is company A? Company A is PNE Industries in 2014.
Price Chart of PNE Industries.
Source : FT Markets