Keeping Your Balance

April 2, 2001

Dear Investor:

This bear market will be recorded as one of history’s most miserable, with the worst collapse for a major index since the Great Depression: the Nasdaq is nearly 65% off its peak. The economy is slowing dramatically and one or two quarters of negative GDP growth are possible. Though most companies have lost ground due to the economic slowdown, the vanquished are those with weak balance sheets.

A company with a weak balance sheet is courting disaster. A weak balance sheet can be defined as one where liabilities are out of proportion to assets. Just as a family of four with maxed out credit cards will not make it through a period of unemployment, so too will a company with significant long-term debt find it hard to weather a recession. During boom times, investors are attracted to companies with significant debt because they are deemed sufficiently leveraged to exploit growth opportunities (i.e. the company is investing all available resources in business expansion and not reserving any in cash). Investors then get lazy. Behind their rose-colored glasses, they cease caring about an over-leveraged corporate condition; after all, in an ever-expanding economy, earnings will always improve.

But as we’ve seen, even in an age of information technology, the economy remains cyclical. The law of supply and demand has not been repealed by the Internet. At a time of declining earnings, a company can rely only on its balance sheet. If weak, it will have only three choices: (1) raise cash in the capital markets, (2) seek the embrace of a stronger acquirer, or (3) file for bankruptcy. As we’ve witnessed through the Nasdaq collapse, the first two options vanish when things go badly. Like banks, capital markets give money only to people who don’t need it. Firms like Pets.com and etoys had to discover this the old-fashioned way: investments in those companies are now worthless.

Of course, even a profitless company with sufficient reserves can be a ticking time bomb. The cash will then be used to fund current operating expenses, not temporary shortfalls. This is why most Internet companies were never worth buying, cash or not. Our managers screen very carefully for companies that are (a) profitable and (b) strongly capitalized. This precludes many newer stocks that are mere concepts disguised as companies.

Investing by the balance sheet is not foolproof. One disadvantage is that the next Microsoft could be among these poorly capitalized companies. But we adhere to Mark Twain’s belief that the return of our money is more important than the return on our money. We prefer to invest only when those companies have demonstrated a profitable business model by earning a buck or two.

The other disadvantage is that the stocks of well-capitalized companies can still swoon in price. In the recent market collapse, even many strongly financed companies in our portfolios have declined. The difference is that their stock prices are unlikely to drift significantly below their book value (the value of assets minus liabilities) for long periods of time. If they do drift below book value without being recognized by the public market, they’ll often be snapped up by an acquirer or taken private through a leveraged buyout. Thus, private market actions can bail out the public retail investor. Note that the investor in a weakly capitalized company has no such built-in protection: the stock price can easily sink to zero because no real assets back the stock. That’s why the stocks of many poor companies will never come back, while those of strong companies probably will.

Investing by the balance sheet is unexciting, and never infallible. It can temporarily leave you behind when poorly capitalized stocks skyrocket during brief manias. But it can also keep a retirement plan on track when the world is melting down. Whether or not the existing slowdown degenerates into full recession, companies with healthy balance sheets will live to tell the tale.