Dear Fellow Investors:
In his book, Great by Choice, Jim Collins points out that companies he defines as great have good luck and bad luck just like all the other companies do. The great companies handle difficult circumstances better than good companies and take the most advantage of the breaks they get in business. One of the reasons they make the most of their business opportunities is the strength of their balance sheet. Strong balance sheet is the seventh criteria for stock selection at Smead Capital Management. To us a strong balance sheet means: 1) no corporate debt, 2) more cash than total debt, or 3) the ability to retire all company debts in a relatively short period of time via the use of the company's free cash flow.
A little history for our regular and new readers is necessary to understand why we place such importance on this attribute of public companies. When I started in the investment business in 1980, one of my first mentors, Floyd Jones, emphasized the importance of owning companies with financial muscle. Over the years, I noticed that he had a great deal of success with his own portfolio and his client’s investments. In the late 1980s, the company we worked for, Drexel Burnham, went from being one of the most profitable private companies in the US to declaring chapter seven bankruptcy in early 1990.
Yours truly woke up on February 7, 1990 with ownership of a large subordinated debenture in a bankrupt company. In the next three years, we learned that we would receive 5 to 7 cents for each dollar we were owed. The lesson for me was simple. Don't own a security which has a remote possibility of ever ending up in bankruptcy and don't make a loan which could put you in the back of the line among the creditors of a business.
Our eight criteria for stock selection were solidified and completed not long after Drexel’s announcement. A number of the eight criteria are risk reducing factors of a high quality business and strong balance sheet is one of those qualitative characteristics in the businesses we seek. Until ten years ago, we had no hard and fast information on why my mentor had done so well on his investments or why strong balance sheets were a predictive factor in long-run out-performance or alpha. We then ran into some seminal research from Ben Inker at Grantham, Mayo and Van Otterloo (GMO).
Analyzing data from the beginning of 1980 and ending at the end of 2003, Inker showed that companies with low leverage (debt) in the S&P 500 index outperformed those with average debt levels by 1% per year. It is a proven provider of long-term alpha. He also has concluded that 75% of the present value of a company is determined by cash flows which come more than eleven years from now. And he concluded that 50% of a company's intrinsic value comes from cash flows coming more than 25 years from today. Long-run survival is a key element in high current intrinsic value and strong balance sheets are a key factor in creating longevity.
Jim Collins saw that great companies handle adversity better than good or average companies. Look to Johnson and Johnson to see what got them through the Tylenol poisoning scare of 1984 and you'll find it was balance sheet strength which allowed them to take all the Tylenol off the shelves and do a massive PR campaign to reassure their millions of customers. What did Apple Computer Company have going for it in the early 2000s, before Steve Jobs and the product development people struck gold with the iPod? They had a strong balance sheet to carry the company across to their good fortune.
Why was Disney (DIS) able to expand its parks and other businesses in 2008 and 2009 when most everyone else appeared to be in a business expansion coma? They had a strong balance. Howard Schultz was able to turn Starbuck's around by closing stores in 2007-2008 and re-engineering how they did business because of the strength of his balance sheet. We contend that all these success stories are not possible without a strong balance sheet to carry a company through the tough times and provide explosive upside in the good times.
We believe a strong balance sheet allows companies we own like Gannett (GCI), Comcast (CMCSK), Cabela’s (CAB) and Nordstrom (JWN) to expand when others fear doing so. Whether it results in near-term success doesn't matter, because it should contribute to the long-term future success of these businesses and increase the cash flows more than 11 and 25 years from now. Events like the pending sale of Apartments.com and Cars.com could be a catalyst for an even better balance sheet for Gannett and the sale of their banking business could give HR Block (HRB) much more flexibility to use their balance sheet to become a potentially great company again. We will continue to search for companies which fit our eight criteria and are glad that we appreciate the importance of having a strong balance sheet.
The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.