Food for thought on investing in companies with negative net worth
JOHN Dorfman, chairman of Thunderstorm Capital in Boston and one of the world's great value investors, rarely buys a stock whose liabilities are greater than stockholders' equity. It's a policy that has served him well but it would leave him with few stocks to buy in Ireland.
Shareholders' equity is one of those metrics which is important to value investors but often ignored by growth investors.
In the present climate, when most people are once again in the value camp, it is worth looking closely at shareholders' equity or book value -- the portion of the balance sheet that represents capital received from investors in exchange for stock (paid-in capital), donated capital and retained earnings.
Mr Dorfman wrote earlier this week that bankruptcy risk was only part of his concern for comparing book value to debt.
"Low debt confers freedom: it gives a company strategic options. High debt is like a straightjacket that can push companies into choices they would prefer not to make," he wrote.
Further problems with high-debt companies include pressure to sell prized assets while keeping divisions that are dogs, simply because they need the money. They may fail to develop new products or make acquisitions because their lenders insist that new spending would violate debt covenants.
So which Irish companies would Dorfman avoid -- assuming for a moment that we can ignore his other exacting metrics.
If we take the ISEQ's top 10 (excluding Swiss-based Aryzta) the answer is explorer Dragon Oil, clinical-testing company Icon and bookie Paddy Power.
These three are the only ones in the top 10 companies on the ISEQ by marker capitalisation where shareholder equity exceeds total liabilities.
In Dragon's case, shareholder equity is around four times liabilities. Icon and Paddy Power both have much smaller surpluses but they look good when compared to the massive gaps seen in the banks and even in well-run companies, such as CRH, Ryanair and Kerry Group. Elan is the only company on our list with negative shareholder equity.
Dorfman reckons the only people who should consider negative-net-worth companies are professional investors and speculators and it is hard to argue with this view.
"Investing in troubled companies is a specialised art. It requires experience and 'feel', as well as a thorough understanding of the target companies' balance sheets and income statements," he wrote earlier this week.
"Most professional investors -- and all amateurs -- should avoid negative-net-worth companies like the plague."
Food for thought.