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How investors can keep on the right side of the balance sheet

Firms that pumped up their earnings at any price are now paying the price, says this analyst, so go with cash-rich stocks — like these two.

To get ahead in this world, you should always have more money than you owe.

That may sound like the kind of thing you’d say to kids opening their first bank account.

But it’s something that’s been widely forgotten by many who are well past the beginner’s stage in finances — including some of the world’s biggest companies.

It’s also the lesson Mr. David Baskin wants to drive home for investors in the latest issue of The MoneyLetter.

Do not be misled by companies who resort to balance sheet tricks to fluff up their earnings, says Mr. Baskin. He turns his attention to a trick that was tried far too many times, the share buyback.

He also recommends two companies that are conspicuous for their absence of trickery and their commitment to the balance sheet.

But he begins with lessons learned from a Scotsman.

Liar, cheat and thief

Mr. Baskin, who runs a wealth management firm and is a frequent guest on business TV, once toiled in anonymity at the Bank of Montreal.

That’s where he learned two very hard lessons about debt. He worked in bad loans — known in more polite terms as the Special Loans Department (nice to know that even if you can’t pay you’re still “special”).

His boss, described as a “crusty Scotsman,” painted no rosy pictures for him. “When times are tough,” he said, “your best customer will become a liar, a cheat and a thief.”

His second lesson resembles an iron law of probability. “A problem on the balance sheet will sooner or later show up on the income statement.”

So it does, Mr. Baskin says, even in the best of company. Giants like General Motors, Citibank and General Electric — “once the most valuable company in the world” — have all tumbled with their balance sheets.

Goosing the earnings

One reason for this collapse stands out in Mr. Baskin’s mind.

“Investors have encouraged companies to manage for higher short-term profit at the expense of long-terms earnings and stability.”

As a result, companies found ways to “goose” their quarterly earnings reports, generating favourable reviews from analysts and plenty of action from investors.

But companies were paying a price for this popularity — and the bill would eventually come due.

The share buyback craze

From 2003 to 2007, the most popular technique companies used to fluff up their earnings was to buy back their own shares.

This had four enticing consequences. First, a buyback automatically makes earnings per share greater. “Since price to earnings is one of the most popular ways to value shares,” says Mr. Baskin, “higher earnings per share means a higher share price.”

Second, it reduces shareholders’ equity, so the return on equity goes up. It also boosts the return on equity by reducing the cash on hand, since cash usually earns low returns.

Third, companies that empty their pockets of cash become less vulnerable to takeovers. Leverage buyout firms like to use the takeover target’s own cash to pay for the purchase. Or to put it another way: “Keeping cash becomes a way for the CEO to keep his job.”

Finally, share buybacks return cash to shareholders either tax free, or at a low tax rate. Unlike dividends, there is no tax unless an investor decides to sell the shares. And these will be taxed as a capital gain.

Mr. Baskin includes a table that shows just how the share buyback craze took off. In 2003, companies on the Standard & Poor’s 500 invested 36 per cent of their earnings in buybacks.

By 2007, that figure was over 100 per cent! The biggest companies in the U.S. were “spending more than they earned to buy back their shares.”

Two rules and two buys

How do you spend more than you earn on your own shares? You go into debt, of course. The interest on debt is tax deductible, Mr. Baskin points out, but sooner or later the debt must be paid.

So some of the most famous companies in the world have seen their debt rise and their equity fall. And their share prices have fallen with it.

This is not a prudent way to run a company, this expert says. Surely companies “should be more concerned about managing their businesses than their share price.”

So learn from the experience, he urges investors. Follow these two rules. “Always remember that earnings per share is an accounting concept more than a reality.”

And two: “Without a strong balance sheet, earnings may not sustain a stock.”

Never ignore the balance sheet, he insists. And consider two ratios — debt-to-equity (total liabilities divided by shareholders’ equity) and debt-to-cash-flow (long-term debt divided by cash flow).

Debt-to-cash-flow may be the most immediate signal of danger. A ratio higher than 2.0 indicates that a firm is dangerously in debt.

Mr. Baskin completes his cautionary tale with strong recommendations for two stocks that stay on the right side of the balance sheet.

Saputo Inc. (TSX-SAP) is a leader in cheese and diary products. And it has mastered the art of acquiring valuable companies without damaging its balance sheet. Its cash flow is way ahead of its long-term debt.

IGM Financial Inc. (TSX-IGM) manages Investors Group and Mackenzie mutual funds. Due to the carnage in the fund markets, this firm is a bargain. And it has the strong balance sheet to flourish as the markets recover — and take market share away from its competitors.

Mr. Baskin has this message for his readers in a href="/newsletters/moneyletter_summary.html">The MoneyLetter. “Unfortunately for investors, on Bay Street and Wall Street who live for the future are often shunned, while those who live in the moment are rewarded.”

Surely it’s not too much to expect that investors who make the right choices today will be rewarded in the future.