The legendary British fund manager candidly shares analysis of his investing disasters.
In Fidelity's star-performing fund manager Anthony Bolton, we have a British investment guru rivalling anything the US can give us. He's up there with the likes of Warren Buffett, Peter Lynch and Benjamin Graham.
When he speaks, given his exemplary investment record, I want to listen. So, I was pleased to discover his 2008 article that reveals three factors he's noticed recurring repeatedly in his investing mistakes. He goes on to finger one of those factors as the most common disaster-inducing cause of all.
Three negatives
He identifies three recurring themes from his investment failures as follows:
- Poor management.
- Ineffective business models.
- Weak balance sheets.
But the number one, most frequently occurring factor involved in his bad investments has been the presence of a poor balance sheet. He cites examples from his Fidelity Special Situations days as companies like Isoft, Scottish Media Group, Erinaceous and Johnson Service Group (LSE: JSG).
Balance sheet weakness
According to Bolton, a weak balance sheet is usually characterised by the presence of lots of bank debt, or debt in the form of bonds. He also cautions investors to look for less obvious debt like pension fund deficits, redeemable preference shares or future liabilities. If the absolute debt level is high compared to the company's cash flow or net worth, the company has balance sheet weakness.
He concedes that debt isn't inherently bad and can have the potential to boost investor gains. Buying a company with lots of debt on its balance sheet is like buying the shares of a debt-free company with borrowed money, he reckons; the shares will have high upside if things go well, and a big downside if things go badly.
Nevertheless, it's important for investors to recognise where they stand with regard to a company's balance sheet. An example of a poor one is found in this summary of electrical goods retailer Dixons (LSE: DXNS) on 15 October 2011:
| | £m |
|---|
| Intangible assets | 1077 |
| Total tangible assets | 2434 |
| Total assets | 3511 |
| Total liabilities | 2829 |
| Net assets | 682 |
| Net tangible assets | (395) |
The liabilities on the actual balance sheet are packed full of borrowings, finance leases, retirement benefit obligations, other payables, deferred tax and provisions. As you can see, if we strip out intangible assets, such as goodwill, which tend to have very low value in a low-tech loss-making business such as this, the net asset figure is negative -- a weak balance sheet.
Comparing the total liability figure to the company's cash flow doesn't provide any comfort either; in the same half-year report, Dixon's reported net cash from operations of just £80m.
Balance sheet strength
It's a different story at sticky bun purveyer Greggs (LSE: GRG), which provides us with a study of balance sheet strength. Here is a summary of its position on 2 July 2011:
| | £m |
|---|
| Intangible assets | 0.4 |
| Total tangible assets | 285 |
| Total assets | 285.4 |
| Total liabilities | 101.4 |
| Net assets | 184 |
| Net tangible assets | 183.6 |
On the actual balance sheet there is no debt in the total liabilities figure, which is mainly current trade and other payables, with small sums for deferred tax and other provisions.
The debt-free company enjoys a healthy, positive net tangible asset balance of almost £184m, which provides a strong financial foundation from which to operate.
Protecting the down side
Often, investors are attracted to an investment opportunity by the upside case, whether led there by an impressive growth record, an attractive PEG ratio, a fat yield or the recovery potential of shares like Tesco (LSE: TSCO), BP (LSE: BP) and Man Group (LSE: EMG), for example.
But when a share grabs your attention, it's a good idea to check out the downside protection before proceeding further. To me, that means scrutinising the balance sheet and the cash flow statement first.
Bolton says that some of his favourite types of shares are those with limited downside and reasonable upside. In his own words:
"These 'skewed' return companies are ones where you shouldn't lose too much money and you might just do very well."
In such cases, he's looking for a strong balance sheet and significant net cash or liquid assets to limit the downside.
A few tips
When it comes to checking out downside protection, Bolton offers this advice:
- Watch out for seasonal variations in debt levels, as the company could be weaker than it looks.
- Always check the net interest figure, as this can indicate that average debt is higher than it appears.
He is not against buying companies with weak balance sheets in some circumstances, but says he tends to buy smaller positions and watches them more closely. If things start to go wrong, he is likely to sell such holdings quickly, even at a loss.
Bottom line
So there we have it. If we flirt with a weak balance sheet, we should do so with our eyes open and with a full appreciation of the risks. If we don't, we could meet our own investing nemesis.
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More from Kevin Godbold:
> Kevin owns shares in Greggs, Tesco, BP and Man Group. The Motley Fool owns shares in Tesco.
