Protection First, Profit Second
It's the beginning of a new year and a new decade for the stock market. So the best thing for investors is to make sure they have a clear understanding of what matters most when investing in general and specifically looking at companies. Most investors assume that the first goal in investing is asset appreciation. Capital gain is ultimately what it's all about but before that step, investors must first focus on asset preservation.
It's The Balance Sheet
The majority of investment mistakes come from too much reliance on the income statement and too little attention to the balance sheet. Before getting excited about profits, investors must always scrutinize the balance sheet.
Such an approach in 2008 would have kept many investors from names like Citigroup (NYSE:C) and Fannie Mae (NYSE:FNM) when they were trading in the single digits. Despite Citi's share price rise since March of 2009, it started 2009 trading over $7 a share. Today it fetches less than $4.
Indeed, 2008 was a horrible year for just about any stock. But consider Ternium Steel (NYSE:TX), one of Latin America's most profitable steel companies, if not the most profitable. During the second half of 2008, shares declined from $30 to less than $5. The steel industry got hammered along with everything else during the downturn. Ternium was a profitable business, had a low cost of production and had a sound balance sheet. Today, the stock is over $36.
In other words, an investor who bought shares before Lehman Brothers and paid $30 a share or so, is up a total of 20% in about a year and a half. Despite the impressive market rally in 2009, the S&P is barely even from then. For more, check out The Characteristics Of A Successful Company.)
Then The Income Statement
Earnings do matter and ultimately they are the catalyst in moving a stock price up. But if a company does not have a balance sheet for weathering storms, profits are an afterthought. A business that turns a profit but loses money due to a deteriorating balance sheet is destroying value. It's that simple.
Remember, a quality balance sheet is the first step, but not the only step. Valuation then takes over. A company like Amazon (Nasdaq:AMZN) has a great balance sheet and is very profitable, but it's valuation is pricing the company for perfection. (For more, see Earnings: Quality Means Everything.)
A Timeless Lesson
The best mistakes in investing are ones that can be learned from. Mistakes can be very valuable if they prevent the same mistakes from happening over again. Pay more attention to the balance sheet and a lot of unnecessary mistakes may be averted. (For more, see The Value Investor's Handbook.)
By Sham Gad
What Does Balance Sheet Mean?
A financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by the shareholders.
The balance sheet must follow the following formula:
Assets = Liabilities + Shareholders' Equity
Investopedia explains Balance Sheet
It's called a balance sheet because the two sides balance out. This makes sense: a company has to pay for all the things it has (assets) by either borrowing money (liabilities) or getting it from shareholders (shareholders' equity).
Each of the three segments of the balance sheet will have many accounts within it that document the value of each. Accounts such as cash, inventory and property are on the asset side of the balance sheet, while on the liability side there are accounts such as accounts payable or long-term debt. The exact accounts on a balance sheet will differ by company and by industry, as there is no one set template that accurately accommodates for the differences between different types of businesses.