Buying Better Balance Sheets – Could there be a low-risk method to improve your margin of safety

• Introduction: Balance Sheet Optimization vs. Conservative Balance Sheets
• U.S. Large Cap: The History of the Cash Rich & Crashes
• Exhibits
• Appendix: Small & Mid Cap

Introduction: Balance Sheet Optimization vs. Conservative Balance Sheets

Longtime Kailash readers have been asking about our various models’ “Balance Sheet” scoring. Specifically, many want to understand why some firms with large amounts of cash on their balance sheets get poor scores and others with lower levels of cash can receive top quintile scores. The simple reason is that while the Balance Sheet module varies across different models, research shows that even in a crash more cash is not always a good thing. The factor weights in the Balance Sheet module work as an integral building block interacting with managerial integrity, earnings quality, the uses of cash flows and numerous other metrics in the broader model to calculate final scoring.

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The purpose of this paper is twofold:

1. Kailash presents data to substantiate the above conclusion that more cash is not always better
2. The paper seeks to find firms with healthy balance sheets, robust businesses and shareholder friendly managements trading at valuations where history suggests they will fare well regardless if March 23rd was the market bottom or if more painful days lie ahead

Kailash believes capital preservation is a topic well worth emphasis in the current environment. As markets ricochet from greed to fear based on headlines about the loss of life, soaring unemployment and wholesale government market intervention, it is easy to lose sight of fundamentals. Kailash believes recent price action validates the theory that totally unpredictable macro events have temporarily drowned out fundamentals.

While macro uncertainty can make fundamental investing seem futile due to price action and facts disconnecting, Kailash firmly believes that these are precisely the times when fundamentals can be most valuable to investors with long time horizons.

The four charts that follow examine the behavior of the 20% of firms in the Kailash S&P500 Universe that have the highest levels of cash relative to market cap. The charts display performance into the trough of the last three crashes and in the subsequent 12 months. The form and order of these charts will be consistent and require limited reading beyond this simple explanation:

1. The first three bars display the performance of the index from the peak to trough (navy bar), performance from the trough to 12 months later (light blue bar) and the compound return of $1 invested at the peak, held through the 12 months after the rebound (the compound return)
2. The second set of three bars display the exact same data except for the 20% of firms with the highest levels of cash relative to market cap
3. The third set of bars displays the performance of a “High Quality” portfolio of the 20 firms within the most cash rich quintile that have the best Returns on Assets, highest FCF/EV and the lowest sales growth – a trailing feature that often results in low future expectations.
4. The fourth set of bars displays the mirror image of the group described above – these are “Low Quality” portfolios of the 20 firms within the most cash rich quintile that have the worst ROAs, lowest FCF/EV and the highest sales growth which commonly leads to high investor expectations.

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