Think of this week’s post as somewhat of a follow-up to last week’s one called “Making the Minimum Credit Card Payment.” Al is someone who read my book, “Choose Stocks Wisely: A Formula That Produced Amazing Returns,” and he has written me from time to time. He has become a friend and our recent e-mail conversations led to today’s post. Al wondered at my thoughts over two issues he read about very recently, namely that weak balance sheets are expected by Goldman Sachs to outperform strong balance sheets looking ahead and that companies with high financial leverage ratios (debt to equity) have outperformed companies with lower debt to equity ratios. The following two links Al sent me are below:

http://www.valuewalk.com/2014/05/weak-balance-sheets-lead-market/

http://www.fatpitchfinancials.com/2256/total-debt-to-equity-ratio-backtest/

Last, week, I talked about how there is a mindset that debt principal never comes due when the money is flowing and capital is cheap. I believe we are in such a time right now. Indeed, so long as circumstances like this prevail, one can make a case that having excessive debt which, of course, can be ascertained from a review of the balance sheet, is a positive thing. After all, borrowing more and more inexpensive (while interest rates are low) money to increase near-term profits is appealing to the one who believes he/she is strictly interested in buying future earnings and unconcerned about the deteriorating financial health of the over-levered company.

It is noteworthy that the linked piece above about weak balance sheets outperforming indicates that tech stocks account for half of the weak balance sheet outperformance of the last couple of years. This grabs my attention and reminds me of a time before I turned to the balance sheet for answers, a time around 2000 when I lost my invested resources due to buying strong earnings in some tech companies that had little balance sheet equity to support my purchase price. When the earnings growth flatlined and then started heading south, so did the stock price and so did my invested resources. As I shared in the early part of my book, disregarding the balance sheet cost me dearly. So, will I personally try to make money again by disregarding the financial health of a company and even purposely choose companies with weak financial health (weak balance sheets)? I’ll leave you to speculate on my answer.

As to the piece linked above about higher debt to equity ratios leading to better investment results, this issue has to be taken in proper context, in my view. Is a higher debt to equity ratio necessarily associated with a weaker balance sheet? That is, does using more financial leverage (debt) mean that the balance sheet equity becomes suspect? No, not necessarily.

Using debt to finance growth has advantages over issuing stock (equity) to finance growth. The cost (interest) of debt capital is cheaper than equity capital (dividends and expected capital gains) because of lower relative risk, tax deductibility and its fixed cost aspect. So, company growth can be elevated by financing operations with debt vs. equity. My balance sheet approach does not identify a quality balance sheet as a debt-free balance sheet but rather a balance sheet that has ample tangible assets at the time it is being evaluated to settle its debt, both short-term and long-term.

I appreciate Al for sharing these pieces. Last week I wrote about the “just need to make the minimum credit card payment” mentality that seems to be pervading our culture today. I don’t know about you; I want to know I have enough assets to settle my debts today if I need to. I want to know the same thing about any company I invest in today. Defining a weak balance sheet as one that is over-levered and can’t settle its  day-to day bills and/or longer term debt today if the money flow slows down, I’m defining a company I’m unwilling to put my hard-earned money into, regardless of how high its stock price might fly in the near term.  I’ve been there and done that.