Keeping your health and fitness at an optimal level requires commitment, consistency and discipline. And this closely mirrors the basic underlying principles of value investing such as long term vision and consistent profitability, in addition to reasonable levels of debt and, of course, attractive valuations.
Now let’s take that analogy one step further. What you put into your body can fundamentally affect your physicality. Similarly, we believe that, from a value investing perspective, the companies that go into a fund or portfolio are crucial to keeping it fit-for-purpose, that is, to deliver value over the long term whilst helping ride out market volatility.
In volatile times, consistency, discipline and long-term vision are more important than ever to keep your portfolio healthy. Good news is, just as there are signs that can be used to assess the health of a person, there are a number of indicators that will help you screen the general health of a company.
A strong balance sheet equals a clean bill of health
Just as an individual’s medical assessment report is a snapshot of his current health situation, a company’s balance sheet is also a snapshot of its financial position at a given point in time.
The balance sheet goes beyond just reflecting a company’s assets relative to its liabilities, it also reveals the economic character of a business by showing its ambition to maximise financial performance and to make the shift from good to great. Maintaining a balanced mix of debt and equity funding is one of the key indicators to spot a strong balance sheet.
Against a background of economic deceleration, some investors hang their hopes on looser monetary policy (i.e. lower interest rates) preventing the economic engine from stalling. As a long-term global investor, I believe a more sensible approach is to invest in companies with strong balance sheets.
Debt Ratio: Everything in moderation
The Body Mass Index (BMI) is used to determine whether the individual is currently at an ideal weight for their size or if they are overweight. An overweight person would accordingly run a higher risk of facing health-related issues.
The debt ratio of a company similarly measures the extent to which a company is “overweight” based on its leverage in terms of total debt to total assets. A lower debt-to-asset ratio suggests a stronger and more balanced financial structure, while the opposite would suggest higher risk because a greater proportion of a company’s earnings go toward servicing debt, especially so if the company’s growth is only attributable to it taking on more debt.
However, from a corporate perspective, the debt ratio alone doesn’t capture the true strengths of a firm. A firm’s value also depends on how robust its business model is - a low debt ratio with poor earnings prospect offers less opportunities than a somewhat higher debt ratio with strong outlook and sound profitability.
As a rule of thumb, value means efficiency; it is about generating the maximum return with a minimum amount of resources, over time and in a sustainable manner, which brings us to our next point.
Company Structure: Keeping lean is the way to go
In the same way that keeping your body lean enhances your overall ability to move with greater ease and economy, having a lean organisational structure allows greater focus and agility.
Lean structures enable companies to create more customer value by using fewer resources whilst focusing more on its core activities than traditional structures. In a nutshell, corporate efficiency goes up and non-value adding practices go down.
From an investment lens, lean organisations are attractive because having a more efficient organisational structure can translate into developing a sustainable competitive edge.
Cash Reserves: Staying liquid is like keeping hydrated
Just like how water is the essential element that keeps the human body functioning, cash is the lifeblood of an organisation that keeps it going.
Having sufficient cash reserves allows a company to meet its expected and unexpected outlays in the short term and also afford the liquidity it needs to capitalise on potential investment opportunities that may come up along the way.
The general rule of thumb with regard to recommended cash reserves is for companies to maintain sufficient cash reserves that can cover up to six months of its average operating cash outflows. However, having too much cash reserves is also a potential drag as it could mean that the firm is missing out on potential investment opportunities.
Brand Value: That elusive X Factor
Being fit and feeling good can also give someone that elusive X Factor. In the age of social media, we have seen that X factor come into play with a proliferation of fitness opinion leaders who are able to make a living by influencing thousands of followers into buying into their “brand”.
The corporate equivalent of that X factor is brand equity. Brand equity describes a brand’s value based on consumers’ perception and cumulative experiences with the brand itself. Simply put, it is a measure of how much a brand is worth.
BrandZ, the world’s largest brand equity database, published their list of the top 100 global brands for 2019 and the brand value of the top ten brands accounted for an estimated USD 2.02 trillion. An astounding amount by any measure.
A company’s brand equity is a powerful intangible asset that allows it to not only differentiate itself from competitors but create strong brand loyalty and advocacy amongst its customer base. The result is both consistent demand for the company’s products and services and also in some cases, the ability to market them at a premium.
Consistent Performance: Slow and steady wins the race
Be it in business or fitness, consistency is key to success. A healthy company is one that is able to perform consistently over the long term.
Businesses that perform consistently quarter after quarter are the ones that have either a sustainable competitive advantage or processes in place that are both reliable and repeatable which ultimately reinforces their ability to deliver consistent outcomes to their investors.
To improve the health of your investment portfolio, look out for companies that offer strong balance sheets, reasonable debt-to-asset ratios, lean structures, sufficient cash reserves and high brand equity. These are positive signs that a value investor would typically follow as they tend to lead to consistent investment performance in the long term. After all, the healthier the companies in your investment portfolio, the greater the probability of growing your wealth in the long run.
We started off this article with an old cliché and by peeling back its layers, we find that the underlying wisdom behind it still shines through. Health equals wealth. For our money? Never more so than from an investment perspective.
A contribution piece by Puneet Chaddha, CEO and Head of Southeast Asia, HSBC Global Asset Management. A version of this piece was first published in The Sunday Times on 27th October 2019.