Why equity investors need a crash course in debt risk.

In ye olden days, equity investors could pay cursory attention if any to the balance sheet, focussing attention on more exciting stuff like growth and market opportunity.

However, two inconvenient truths today mean that equity investors need to pay attention to the boring old balance sheet:

  • Many companies funded the lack of revenue caused by the pandemic by using debt, which led to many bankruptcies.
  • even if a business emerges from bankruptcy so that customers and employees are fine, equity is wiped out – yes, that is 100% loss if you own the equity!

The good news is something as boring as a strong balance sheet will lead to exciting growth opportunities as weaker competitors go under. Survival of the fittest Darwinism is tough unless your business is a survivor and picks up market share from competitors who went bankrupt.

During these times when debt is almost free with low to negative interest rates, zombie companies may survive that should go bankrupt. If you want to bet on that, ignore the balance sheet.

If that seems too risky to you, the crash course in debt risk for equity investors means looking at both long term and short term debt risk.

Note, equity investors only need a simplistic crash course in debt risk. If you invest in debt, you will need to go a lot deeper.

The reason that equity investors can live with a simplistic crash course in debt risk is that growth is still key. Take the example of Occidental  (OXY) which had a very weak balance sheet; but equity investors did well by betting that a stronger oil price would lead to cash flow growth that would fix the balance sheet.

Venture backed companies exiting via IPO typically have strong balance sheet as most early growth is funded by equity capital. However, venture backed companies exiting via IPO typically have very high valuations. To find good  risk adjusted growth at the right price, investors need to analyse revenue growth AND debt risk AND valuation.

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