Hey friends. I hope this last Saturday in February 2016 finds you well. Wow, 2016! Each year about this time I’m really struggling with getting adjusted to the new year number; I’m still working with 2015. About the time I’m completely adjusted to what year it is, it has rolled over to the next one. You don’t have that struggle, do you:)

The use of debt to lever earnings is widely practiced. After all, the interest cost of debt financing is fixed regardless of how much is earned from the assets financed thereby, the cost is generally lower than equity financing, and interest is tax deductible to the corporation whereas dividends paid are not. When revenues for a profitable company are on the upswing, debt financing can push the bottom line higher faster than if equity financing was employed. But when revenues are falling and profits become losses, debt can become onerous in a hurry, pushing a company toward a financial cliff much faster than the use of equity capital since no payments to equity holders are assured as with debt holders.

This prelude about the use of debt is given to introduce an article from this past week in The Motley Fool entitled “This Billionaire Lost a Boatload of Money on Energy.” Go to this article to read about the huge unrealized losses being amassed by Carl Icahn with his investments in energy stocks. In the previous sentence I say “unrealized” because there’s nothing to indicate stock positions have been sold yet.

However, if the energy commodity prices don’t rebound, the balance sheets of even some of the biggest companies in the space, such as those mentioned as stock holdings of Icahn may not survive since they are already burdened by large amounts of debt against low levels of working capital, and this burden is happening in the face of dire forecasts for near term profit and free cash flow.

The following is a quoted section from the article:

“Investor takeaway
Carl Icahn big energy bet has blown up in his face because the companies he invested in borrowed heavily to build their companies around two megatrends. That debt is now a big weight because those trends are on hold while the industry sorts out its near-term overcapacity issues.

Icahn’s story is a reminder that debt works both ways. It leverages gains in good times and losses in bad times. The takeaway is clear, even the best investment thesis can blow up when it’s being fueled by debt.”

I emphasize this quote because if highlights why a full analysis of the balance sheet is essential for proper risk assessment before investing in stocks. Ideally, when we invest, we want to see a strong working capital position against a low or very manageable level of debt with a company that has recently been and is presently seeing profitability, and further, where management makes comments about the company’s future that are favorable. This last sentence expresses the nuts and bolts of my investing strategy delineated in “Choose Stocks Wisely.”

With regard to commodity prices, I’ve written about this topic before several times over the past year or so and continue to believe that what it does from here is likely the greatest indicator of what happens to the economy and the stock market. Because a healthy balance sheet is required to enable a healthy economic future, the lack of financial health with such an integral component of our economic infrastructure, namely energy, is surely problematic and in need of repair sooner than later. While very depressed oil prices may be good for the consumer’s pocket in the short run, they are putting dire pressure on the energy sector’s health. In the long run, rebuilding supply when it becomes needed won’t likely occur overnight and we could become more at the mercy of foreign oil producer decisions. So, while paying lower prices is a pleasant experience, my personal view is that we need to see oil prices rebound soon.

Thanks for reading.