Equity is the excess of assets over liabilities. It is ownership. To really have ownership, there has to be a surplus of resources above all obligations.

Yet, in the world of stock market investing, it often appears that equity doesn’t matter. There are numerous examples of high-flying stocks where stockholders own nothing but the right to future earnings because there’s no equity whatsoever on the balance sheet. In fact, you can find numerous large well-known companies that have obligations that exceed their resources by a wide measure. That is, their liabilities exceed their assets, equating the meaning of insolvency. Further, in many of these situations, the assets even include a significant measure of goodwill and intangible assets.

It is true that the asset and liability numbers on the balance sheet do not reflect true market values in many cases, but it remains that the buyer of stocks in such situations may possess nothing actually beyond the right to future earnings.

As emphasized in my book, “Choose Stocks Wisely,” a share of stock represents ownership in a company. First and foremost, it should represent an equity stake where real equity is already present. Why would I take the risk of acquiring nothing tangible in order to attain the right to participate in future earnings that may or may not transpire? But we are witnessing the market living more and more on the ragged edge by the concept of compromising the balance sheet health in favor of more and more leverage (debt) being assumed toward the prospect of squeezing out another dollar of profit.

Yes, the stock market today is much like everything around it. There is a pervasive attitude that goes well beyond the practices of companies trading stock on public exchanges that says you can always refinance your way out of ever having to truly settle your liabilities. Our nation functions according to this premise. But it’s a very false and dangerous premise, in my view. Debt cannot forever be rolled over. To have a healthy financial status, assets do have to be built up and ample assets reserved for not only paying bills coming due day by day but also for settling long-term borrowings at maturity.

You know, we’ve grown accustomed to seeing the Fed reduce interest rates and then keep them near zero. Relative to stock investments, companies have benefited from seeing more profits due to a lower cost of capital. Yes, companies have profited for quite some time simply by refinancing in an environment of controlled and falling interest rates.

But, hey, didn’t the Fed just raise rates marginally? What will that do to the cost of capital for an over-levered company? What will that do to profitability? What will that mean when the company has to refinance at a higher interest rate? Will the balance sheet liquidity and sufficiency become more or less important with increasing cost of capital? These are important questions to ponder.

In my opinion, the predominant market view seems to suggest that we have arrived in some kind of golden age where the only thing that matters is company earnings, regardless of what it means to the health of the balance sheet. Why should one care about the equity position reflected on the balance sheet? After all, debt can always just be rolled over; so the obligations really don’t matter that much. Right?

With all my strength I’ll shout “wrong!!!” The primacy of equity has been forgotten as we’ve all witnessed for many years now the delaying of debt repayments in an easy interest payment environment of minuscule interest rates and refinancing deals. This environment has permitted stock prices to be driven almost exclusively by earnings without any real regard for the underlying health of equity revealed on the balance sheet. Again, I’ll avoid naming companies here on this forum but I’m aghast at the high market values being assigned to many that have very unhealthy balance sheet positions and are not prepared to weather a financial storm, should it arise.

Yes, it may even “seem” today that equity does not matter too much and that big profits are all that count. But equity will always matter because the balance sheet will always matter. And it matters the most when a company’s success with profitability gets sorely tested by tough times.

Just check out companies in the oil and gas services sector today. Those companies that emphasized the importance of maintaining a healthy equity position while responsibly pursuing profitability during the good times rather than compromising the balance sheet in order to net another penny to earnings per share are on a sound footing; they have the balance sheets that reveal it. And even though their stock prices have suffered, they stand to benefit greatly when the worm turns with oil and gas prices. Unfortunately, many other companies in the sector which had leveraged their futures for another penny of profit (living for the moment) during the good times have either already bitten the dust or are getting treacherously close to that outcome.

This was not intended as a pessimistic post. Nor was it a post to say that earnings don’t matter. Earnings do matter and, if operations are managed well, earnings are the path to building additional company equity. But earnings do have to be pursued responsibly, meaning “don’t compromise the health of equity.”

I wrote this today because I believe that evaluating the health of equity is more necessary than at any time I can remember. Many companies are still stewarding the balance sheet well and are much less risky should tough times come along relative to those who have made it “all about earnings.”

I’ve been posting weekly since late summer of 2013. Please look for my future posts to occur about every 10 days to 2 weeks. Grandchildren won’t stay little for long.

May God bless you during 2016. Happy New Year.