Investors love “story stocks” – companies operating in exciting industries on the forefront of innovation and disruptive new technologies. Internet stocks were all the rage in the late 1990s, but many crashed and burned when the sober reality of their current corporate financials clashed with stratospheric valuations based on dreams of future unlimited riches. “Hot” industry sectors today include social media, 3-D printing, big data, and alternative energy/clean tech.

But just as Internet companies Pets.com and Webvan.com turned out to be investment disasters despite the success of the Internet, so too will many companies in the today’s new and exciting industries also fail despite the success of the industries as a whole. As Wharton finance professor Jeremy Siegel wrote in his 2005 classic investment book The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New, stock bubbles caused by investor excitement over new technologies always end badly:

Although a disaster for investors, there is a silver lining to these euphoric episodes. They have marked, and perhaps encouraged, many of the advancements that have occurred in the last three hundred years, from the canals and railways to the automobile, the radio, the airplane, the computer, and the Internet.

But history proves that it is best to let others fund these innovations. Originality in no way guarantees profits. In fashion, you may want to buy what everybody else is buying. In the market, such impulses are a road to ruin.

Although some initial public offerings (IPOs) are great investment successes (e.g., Cisco Systems, Dell, Microsoft, Home Depot), the vast majority are disappointing because the issuers (i.e., sellers) decide when to go public and they rationally do so when their companies are experiencing peak profitability and/or when investor enthusiasm for an industry fad is at its highest.

Sellers are smarter than buyers. Consequently, buyers need to be educated. Knowledge is power and the best way to become knowledgeable is to read a company’s financial statements. The Securities and Exchange Commission (SEC) requires all publicly-traded companies to publish quarterly financial statements so that investors have a fighting chance against the sellers.

Balance Sheet is Most Important of Three Financial Statements

The main three financial statements produced by publicly-traded corporations are:

1. Balance sheet
2. Income statement
3. Statement of cash flows

All three are important in understanding a company’s financial health, but the balance sheet is arguably the most important. Fund manager Richard Bernstein, who used to work at Merrill Lynch as its chief investment strategist, wrote a parting letter in March 2009 soon before he left the firm. The letter consisted of 10 market guidelines he had learned during his 20 years as a stock-market analyst. Number 6 on the list was: 

Balance sheets are generally more important than income or cash-flow statements.

Fund manager Bruce Berkowitz also favors the balance sheet, stating (video timestamp 13:25 to 15:15):

There are less ways to cheat on a balance sheet than an income statement.

The reason that the balance sheet is more important is because it offers a reflection of the entire company – a “full body scan” in medical terms. Although it is a snapshot of the company’s condition at a particular point of time, it is a complete snapshot and represents the accumulation of total wealth over several years. Most investors look first at the income statement (i.e., earnings), but earnings are nothing more than the comparison of two balance sheets and calculating the change in the balance sheet’s shareholder equity (i.e., retained earnings) plus dividends paid. The total value of a company’s shareholder equity (i.e., book value) is more important than one year’s change in that equity.

For example, Dean Foods (NYSE: DF) earned $3.33 per share last year whereas Devon Energy (NYSE: DVN) lost $4.85 per share. Based on their income statements, a share of Dean Foods must be more valuable than a share of Devon Energy, right? Wrong – Dean Foods trades at $10.31 and Devon Energy is trading more than five times higher at $55.00. The reason is that Dean Foods has a book value per share of only $4.57, whereas Devon Energy has a book value per share of $48.54.  A year’s worth of incremental wealth (earnings) is much less important than the wealth that a company has accumulated over its entire lifetime (book value).

Two Ways to Value a Company

Legendary value investor Seth Klarman, in his out-of-print classic “Margin of Safety,” wrote that there are two main ways (pp. 133-34) to value a publicly-traded company: (1) as a going-concern, in which case you perform a discounted cash flow analysis, or (2) as a liquidation, in which case you look at the balance sheet and calculate what would be left over for shareholders after all assets have been sold and all liabilities paid off.

Remember from accounting class:

Assets = Shareholder Equity + Liabilities

A balance sheet has two columns and can be thought of as the sources and uses of capital. The left-hand column consists of the company’s assets – which are the uses of capital. The right-hand column consists of shareholder equity (capital invested by owners of the company) and liabilities (capital owed to non-owners that must be paid back at some point) – which are the two sources of capital. The total dollar amount of each column must equal the other column because each source of capital is used for something (even if it is just cash savings).

Shareholder equity – also known as book value – should always be examined when evaluating the value of a company’s common stock in a liquidation valuation. If the stock price is below the book value per share, the stock is typically considered undervalued. A stock price above book value can also be undervalued if future cash flows/earnings are significant enough, however. But a bird in hand (book value) is more certain and consequently worth more than birds in the bush (potential but unrealized future cash flows).

When performing a discounted cash flow (DCF) analysis in a going-concern valuation, the largest component of a company’s value is the “terminal value” – the calculated value of all discounted future cash flows a company is expected to generate in perpetuity after it has fully matured and reached a stable growth rate in line with the general economy. The terminal value is always a large proportion of total value (slide no. 48) because perpetuity is a long time compared to a 10-year model. Theoretically, the current stock price should equal the present value of all future cash flows – which is larger than the terminal value – but the terminal value can be larger than the stock price if the stock is currently undervalued (i.e., the market is inefficient).

Do not add current book value in the DCF valuation because the DCF analysis assumes that the company is a going concern forever and assets will never be liquidated. However, because the company could unexpectedly fail sometime in the future and the future cash flows may not materialize, it still is a good idea to consider current book value when investing in a stock.

Keep in mind that book value is based on accounting cost, not current market value, so if assets have appreciated in value since their purchase, book value will understate true value. This explains why stock prices often are higher than book value per share. Due to the concept of conservatism, accounting rules do not allow companies to increase asset values if their current market value is higher, but companies are required to reduce asset values if current market value is lower (through impairment charges). Consequently, when a stock is trading below book value – especially “tangible” book value (excluding intangible assets like goodwill, patents, and trademarks), it is a pretty good indication of undervaluation.

Two Ways to Assess Bankruptcy Risk

Liquidity measures a company’s ability to survive in the short term by paying back current liabilities on time. Assets are either “current” (likely to be converted to cash within 12 months) or “non-current” (not likely to be converted to cash within 12 months). Similarly, liabilities are either current (likely to be paid in cash within 12 months) or non-current. In general, companies are stronger and safer if they have more of their assets current and more of their liabilities non-current. An important balance-sheet metric is the “current ratio,” which measures the amount of current assets divided by the amount of current liabilities. Strong companies typically have a current ratio of 2 or greater. Even more conservative short-term metrics of liquidity are the “quick ratio” – which includes all current assets except prepaid expenses and inventory (inventory often cannot be sold or must be marked down) — and the “cash ratio” — which includes only cash and cash equivalents like marketable securities (excluding prepaid expenses, inventory and accounts receivable/credit sales). Quick ratios should be at least 1.0 and cash ratios should be at least 0.5.

Solvency measures a company’s ability to survive in the long term and compares shareholder equity versus total debt. What debt-to-equity ratio is considered safe varies by industry, but generally debt should be no higher than 50% of equity – which equates to 33% of total capital (debt plus equity). This ratio doesn’t include any consideration of a company’s cash-flow generation ability and is therefore a conservative measure of survivability. The thinking is that even if a company doesn’t generate any cash flow to service debt interest, if shareholder equity is sufficient to buy back all of the debt that has been issued then the company will not go bankrupt. Furthermore, some debt contains financial covenants that require the debtor to pay back the debt in full if they are violated. If accelerated repayment of both interest and principal is triggered, merely having enough cash flow to cover interest payments will be insufficient to avoid bankruptcy.

A less-conservative solvency ratio measures a company’s ability to cover debt interest expense with cash flow: the EBITDA-to-Total-Interest-Expense ratio. EBITDA stands for earnings before interest, taxes, depreciation, and amortization and is a measure of cash flow (albeit one that ignores taxes, working capital changes, and capital expenditures). Generally, an EBITDA ratio of greater than 2.5 times interest expense is needed for safety. The 2.5 level may seem excessively high, but it takes into account the fact that debt payments are fixed and certain, whereas EBITDA is variable and uncertain. Consequently, you want a cushion in case business conditions temporarily deteriorate and EBITDA declines.

Negative Shareholder Equity Companies Can Have Value, Too!

There are many examples of publicly-traded companies with negative shareholder equity that retain value. For example, the natural cosmetics company Bare Escentuals was laden with significant debt at its 2006 IPO and had a negative book value from 2006 through 2008 and yet had enough cash-flow generating capacity to dig itself out of a hole and score an $18.20 per share takeover offer from Japanese company Shiseido (OTC Markets: SSDOY) in 2010. Current examples of negative-book-value firms include solid companies like AutoZone (NYSE: AZO), Dun & Bradstreet (NYSE: DNB), HCA Holdings (NYSE: HCA), and Domino’s Pizza (NYSE: DPZ). In these cases, the negative equity was self-imposed based on significant share buyback activity (treasury stock is subtracted from shareholder equity) or incurring debt to pay cash dividends.

In conclusion, the balance sheet provides two separate types of useful investment information. First, by looking at a company’s book value per share one can get a sense for whether the current stock price is expensive or cheap. Second, by calculating some liquidity and solvency ratios using assets, liabilities, debt, and shareholder equity, one can assess the riskiness of a company and the probability that it will go bankrupt if business conditions deteriorate and future cash flows are less than expected.   

Stock Screens

Using my trusty Bloomberg terminal, I screened for small and mid-cap stocks that have strong and weak balance sheets. Stocks with strong balance sheets are low-risk and may be good candidates to buy, whereas stocks with weak balance sheets are high-risk and may be good candidates to avoid or short.

Small/Mid-Cap Companies with Strong Balance Sheets

Small/Mid-Cap Companies with Weak Balance Sheets

Source: Bloomberg

Around the Roadrunner Portfolios

Brocade Communications (Nasdaq: BRCD). After guiding down second-quarter results on May 1^st, the computer company reported second-quarter results slightly better than the preliminary guidance ($0.17 EPS vs. $0.15-$0.16 EPS guidance). However, in the conference call management subsequently offered third-quarter guidance below analyst estimates due to storage area network (SAN) weakness. The good news is that the fiscal third quarter should be the SAN revenue trough and growth should resume thereafter:

Our OEM partners are expecting a return to growth in storage during the second half of calendar 2013, and we believe our SAN business will see the benefit of this but it will be outside of our fiscal Q3.  

ISI Group upgraded the stock to a buy with a $7.50 price target, stating that there are “catalysts on the horizon.” Specifically: (1)  higher earnings per share after a $100 million cost-reduction program is put into effect; and (2) the likelihood that the company will start paying a dividend..

Buckle (NYSE: BKE). First-quarter financial results were slightly disappointing, with earnings per share down and revenues up only a bit, missing analyst estimates on both measures for the first time in almost two years. In the conference call, CEO Dennis Nelson blamed the earnings miss on a change in manufacturers of its private-label denim clothes, that caused the new styles to arrive in stores later than expected and consequently some potential sales were forfeited during the spring selling season. That inventory problem has been corrected, so the second quarter should look much better. We already have evidence of an improvement, with May same-store-sales rising 4.1 percent, which was much better than analyst estimates of only a 3.3 percent increase.

I’m not worried about the earnings miss because the last time the company missed earnings was in August 2011 and Buckle’s stock price has outperformed the S&P 500 ever since. In fact, the stock recently hit an all-time high and has made Daniel Hirschfeld — the company’s reclusive chairman of the board — a billionaire. According to brokerage firm Imperial Capital, which raised its price target on the stock after the earnings miss:

The Buckle remains one of the best operators in the specialty retail industry, in our view, with robust free cash flow, a differentiated product assortment, shareholder- friendly management, and long-term square footage growth opportunities.

A recent Seeking Alpha article is very positive on Buckle’s future, stating: “Buckle holds substantial long-term growth potential.” Furthermore, the author projects Buckle’s strong cash flow will enable it to pay up to a 6.6% dividend yield by 2015 (based on the current stock price).

Carbo Ceramics (NYSE: CRR) has published a new investor relations presentation that is very impressive. Bottom line: the company is the largest ceramic proppant company in the world and produces the highest-quality proppant in the world. Slide no. 7 discusses a “breakthrough innovation” in proppant for deepwater wells in the Gulf of Mexico. Slide no. 9 discusses the company’s entrance into the lower-end sand proppant business with a higher-quality resin-coated sand (RCS). Purveyors of lower-quality sand proppant like US Silica (SLCA) and Hi-Crush Partners (HCLP) better watch their back because Carbo Ceramics is gaining on them! Slide no. 38 demonstrates Carbo’s commitment to returning cash to shareholders with 12 consecutive years of dividend increases.

Lastly, a June 3^rd article on Seeking Alpha is very positive on Carbo Ceramics because of its superior product, strong balance sheet, and low valuation. Institutional investors are bullish on the stock, with net purchases over the past quarter equaling more than 6.5% of the company’s equity float.

Future Fuel (NYSE: FF) released excellent first-quarter financials with earnings per share up 94% and revenues up 8 percent, both of which beat analyst estimates. In the conference call, then-CFO Christopher Schmitt was optimistic biodiesel prices would remain “firm” throughout 2013:

The market is speaking right now that, and it’s forecasting good prices for biodiesel. Right now, the market seems to be saying that prices are firm and hopefully will remain so going forward.

On June 1^st, Schmitt was replaced as CFO by Rose Sparks, but I’m not worried because Schmitt is staying within the FutureFuel family, moving over to work at Apex Oil, an affiliated company of FutureFuel Chairman Paul Novelly.

In the conference call’s Q&A, an analyst asked about the effect the “Diamond Green Diesel” processing plant in Louisiana – scheduled to commence operations by the end of June – will have on FutureFuel’s feedstock costs. DGD is a joint venture between Darling International (DAR) and Valero Energy (VLO) that plans to consume 11% of the country’s animal fat waste in its biodiesel production. Analysts are concerned that DGD’s consumption will reduce FutureFuel’s feedstock supply and consequently increase its production costs, thus cutting into the company’s profit margins. President Lee Mickles admitted that DGD was a “concern,” but said that FutureFuel can easily switch from animal fats to corn and palm oils as its feedstock:

We’ve demonstrated an ability to define the feedstock. We can use a wide range of them. This is one of the great advantages we have at our site is having the tankage to take the feedstock at what I’ll call add opportune times for the producers and be able to store that feedstock in the finished product as well.

So, I think we have some significant advantages vis-à-vis some of the other producers in the biodiesel side if, in fact, you get a tightness in that [animal fats] market.

The 2008 Farm Bill – which established several subsidies for renewable energy production (including biodiesel) — expired on September 30, 2012, but the American Taxpayer Relief Act of 2012 extended all 2008 farm bill provisions for one additional year until September 30, 2013. Among the extended provisions included biodiesel credits. Still, the extension is a stop-gap measure and a new multi-year Farm Bill is needed. Bills floating through Congress right now are Senate Bill 954 and House Bill 1947. Of the two, S.954 – which passed the Senate on June 10^th — is more biodiesel friendly because it contains mandatory funding of subsidies (pp. 126-27), whereas H.R. 1947 (not yet passed in the House) provides only loan guarantees and “discretionary” funding (subject to sequestration). Needless to say, FutureFuel would prefer that the Senate bill become law.

United Therapeutics (Nasdaq: UTHR). Two positive articles on the biotech company’s future prospects have been published on Seeking Alpha recently, one on May 24^th and another on June 4^th. The gist of the bullishness on United Therapeutics involves: (1) market-leading treprostinil drug treatments (subcutaneous Remodulin and inhalable Tyvaso) for pulmonary arterial hypertension (PAH) that are just starting to enter the high-growth Asian markets; (2) likely approval of improved (i.e., less frequent) dosing versions of Remodulin and Tyvaso, not to mention the still-possible oral form of treprostinil; and (3) a strong drug pipeline of treatments for neurological disorders, cancer, and viruses.

CommVault Systems (Nasdaq: CVLT) posted fabulous fourth-quarter financial results that saw record revenues and earnings, both of which easily beat analyst estimates. The stock shot up 13% intraday to a new all-time high before reversing to finish down 1.9% on the day. Why the wild roller-coaster ride? The good news is that during the conference call CEO Robert Hammer was extremely optimistic about the long-term future, partly because of the megatrend known as “big data”:

There has been high market demand for big data software solutions to solve problems related to data growth, complexity and cost reduction. We had an outstanding Q4 and fiscal 2013, achieving record revenues and earnings. We have established a firm foundation for fiscal ’14 despite the lingering macroeconomic concerns. Simpana 10 was successfully brought to the market with the most comprehensive launch in our history.

We enter FY 2014 in a much stronger competitive position than ever before in our company’s history. We are well on track in establishing the product distribution services and support and marketing foundations to enable us to achieve our $1 billion planned revenue objectives, as well as to achieve our mid-20s operating margin objectives over the next few years.

In the short term, however, Hammer sounded cautious due to increased operating expenses, macroeconomic weakness in Europe, and an industry-wide slowdown in tech spending:

While we had a strong Q4, I would like to add the following words of caution regarding our future outlook. We are entering our fiscal ’14 with increased risk tied to the apparent near-term slowdown in tech spending in addition to our normal Q1 challenges due to seasonality. In broad scope, our outlook for FY ’14 includes earnings risks related to the macroeconomic environment and our increasing investment in operating expenses across all segments of the business. As a consequence, there could be a significant negative impact to our earnings if we miss our revenue targets.

Bottom line: CommVault remains one of my favorite ways to play “big data.” Higher operating expenses could crimp profit margins, but investors will look past this issue if they are convinced that the expenses will boost profits down the road. The new all-time high the stock hit on May 7^th signals to me that more new highs are in the offing later this year after the first-quarter seasonal weakness is in investors’ rear-view mirror. On June 18^th, Pacific Crest Securities upgraded the stock to outperform and set a price target of $92, stating that CommVault is “gaining market share and should benefit from a new product cycle.”

HMS Holdings (Nasdaq: HMSY) announced that the Centers for Medicare & Medicaid Services (CMS) had changed its mind and will not give HMS the Medicare Coordination of Benefits (COB) contract that it was initially awarded in September 2012. The incumbent COB servicer had appealed the September award to HMS and the appeal was victorious.

This news is disappointing because HMS management had been confident that the September award would be upheld. The COB contract involved helping CMS identify the 4 million people on Medicare that also have another form of health insurance that should pay claims instead of Medicare. It represented $60-$65 million of potential revenue in 2014 and about $0.05 per share in EPS. In other words, removing the contract wipes out 9% of revenue and 4% of EPS.

According to analysts at Wells Fargo Securities, however, the loss of the COB contract isn’t too serious because it was a “cost-plus” contract with low profit margins. In contrast, the Medicare Recovery Audit Contractor (RAC) contract offers HMS high profit margins because the work requires sophisticated data analysis to uncover fraudulent Medicare claims – an HMS specialty. It is very likely that HMS will be re-appointed as a RAC administrator in the re-procurement process because HMS is an incumbent that has done an excellent job for CMS (50% more productive on average and charges the lowest fees). CMS is scheduled to announce the RAC re-procurement awards for the 2014-18 contractual period in either July or August.

G-III Apparel (Nasdaq: GIII) announced an excellent first-quarter financial report, exceeding analyst expectations for both earnings and revenues, and the company increased its earnings guidance for full-year 2013. Sales grew 19% and the company experienced its first profit during a fiscal first quarter in at least the past 15 years! On June 4^th, the stock skyrocketed 18% on the news. Unusually cool weather in the January through March period helped boost full-price sales of coats, which typically need to be marked down significantly as clearance items in anticipation of spring. As a result, gross profit margin rose by four percentage points. The strong performance was also helped by the company’s diversification efforts outside of coats – Calvin Klein dresses, handbags, and sportswear combined with Vilebrequin swimwear and Wilson’s leather goods to produce stellar double-digit growth. In the conference call, CEO Morris Goldfarb described his optimism about the state of the business this way:

This was a very solid quarter with strength in our business across the board. We saw sales increases in nearly every major category. We shipped well, sold through well, built our order book and pushed forward on our growth initiatives. As a result, we remain confident in our plan, both operational and financial, for the full year.    

With the introduction of an Ivanka Trump line of dresses next fall, the company’s growth momentum should continue. Technically, the 1.9 million shares traded on June 4^th were the most in more than a year (Dec. 2011). The volume spike combined with the 18% price rise sending the stock to a record high makes the chart look very bullish for continued price gains.

HomeAway (Nasdaq: AWAY) issued a new investor presentation that is very impressive and bullish about the future. When you combine 36% annual revenue growth with 20% annual listings growth, a 75% subscriber renewal rate, strong free-cash-flow generation, and market-leading network effects, it’s hard not to be enthusiastic about investing in HomeAway. 

Pricesmart (Nasdaq: PSMT) announced that May same-store sales were up 9.8%, which significantly beat analyst forecasts of only an 8.2% gain. Total May sales were up 14.8%, much higher than April’s sales gain of only 10.7%.  The stock shot up 4.3% on the good news, as investors are optimistic that the Latin American warehouse club is experiencing a resumption of strong growth after a prolonged lull.

On May 3^rd, Pricesmart opened its third warehouse in Colombia, bringing its company total to 31. Columbia is a much-larger country in terms of population than any other Latin American country that the company has entered to date, so successful penetration of Columbia could be the game changer needed to bring Pricesmart to the next level. According to a recent Seeking Alpha article, success in Columbia is the key to Pricesmart’s continued strong growth:

If PSMT can demonstrate success in Colombia, it should be able to sustain strong growth for a very long period of time. Colombia would expand its target market by approximately 80%. Furthermore, Colombia is a wealthier country on average than the rest of the PSMT markets combined.

U.S. Physical Therapy (Nasdaq: USPH) reported that first-quarter earnings fell 18.4% year-over-year. Analysts were expecting an earnings-per-share decline, but the actual result was worse than expected by two cents. So why has the stock skyrocketed 19.9% in value since the May 9^th report? Forward guidance, of course! Management projects full-year earnings of between $1.51 and $1.56 per share, which is better than the $1.51 analysts were expecting – especially given the weaker-then-expected first-quarter number.

Furthermore, the weak first quarter was caused by the reduction in Medicare reimbursements and one-time negatives: “multiple storm systems that battered the East and Midwest earlier this year and a worse than normal flu season.” Business was bad in January and February, but improved markedly during March, the last month of the quarter. Earnings per share in March were $0.14, double the EPS in January!

Lastly, the company continues to grow through acquisition with two large purchases so far in 2013 — the most recent on May 28^th  involving a five-clinic practice that sees approximately 36,000 patients per year and produces total revenue of $3.8 million. In the conference call, CEO Christopher Reading said that although the regulatory environment for healthcare is “getting more difficult and more complicated,” a silver lining to the increased regulatory complexity is that it “will serve as a catalyst for some of these privately-held physical therapy companies to look to us to partner with them to assist them with their growth.”