Invest Wisdom

During the last few days I’ve introduced the balance sheet and written about current and long-term assets. Today it’s on to liabilities.

Liabilities (when it comes to balance sheets) is just a fancy word for debt. Just as it is with your own finances, not all debt is bad. Companies have to borrow money just to function.

Current Liabilities

Current liabilities are all debts that are due within the year. While companies can drown in long-term debt, these debts are the most urgent. If a company can’t refinance the debt or come up with a large amount of cash, you can expect a bankruptcy filing to come soon.

You’ll notice that some categories of current liabilities have mirror images on the “assets” side of the balance sheet. Just as a company has accounts receivable, it could have accounts payable, which is money it owes for recent purchases.

Short-term debt is pretty self explanatory. Companies often borrow money for a very short amount of time to account for temporary deficiencies. If, for example, a company just sold several airplanes for several million dollars but it hadn’t collected the money yet, it might need a short-term loan to make payroll.

The market for commercial paper, one example of short-term debt, froze up last year, soon after Lehman Bros. went bankrupt. So even profitable companies were at risk of bankruptcy simply because of timing issues regarding their debt payments.

Long-term debt that is coming due within the year is also a current liability. Unlike, say, a mortgage, where you pay down the debt and pay interest simultaneously, when companies issue bonds, most of the time they pay the interest only. Then, when the debt matures, they pay the principal back.

So if a company issued $100 million in bonds at 6% interest for 30 years, they’d pay those bond holders $6 million a year in interest. But after 30 years, the entire $100 million comes due.

Most of the time, companies can easily refinance that debt at current interest rates. Right now, while the credit market has gotten better, they still might have to accept unfavorable terms for the new loans.

Even if a long-term debt isn’t technically a current liability, it makes sense to check the footnotes of the balance sheet to see when the rest of the debt is coming due. If it’s within the next few years, just understand that that could be a huge, erm, liability for the company as it looks to refinance.

Long-Term Liabilities

This is simply any debt that comes due outside of the year. The less long-term debt you see on the balance sheet, the better. While companies might have to make short-term borrowings all the time, it’s better if you can find companies that don’t have to finance things long-term.

If a company doesn’t carry any long-term debt, it indicates that its earnings power is strong enough that it can self finance major improvements needed for the business. Depending on the industry, this might not be feasible. So you can often glean a lot about a company’s management by comparing debt to other company debt in the industry.

Excessive long-term debt can also come from a leveraged buyout, where the purchaser borrows a ton of money against his target’s current cash flow. The Tribune Company, for example, while very profitable, is under a mountain of long-term debt because of its buyout by Sam Zell.

Other Liabilities

These include deferred income tax and minority interest. Deferred income tax is tax that the company has been able to hold off on paying for one reason or another. Minority interest is shown on the balance sheet when one company has acquired another. If, for example, Coca-Cola bought 90% of Joe’s Soda Shack, it could put 100% of Joe’s assets and liabilities onto its balance sheet. But to show that it didn’t own the entire company, the value of that remaining 10% is filed under Minority Interest.

That’s it. Subtract the total liabilities from the total assets and you get shareholder’s equity (i.e. book value). I’ll explain why that’s important and write about the ratios that investors look at on a balance sheet when I get back on Monday.

— Joe Light

Current assets, which I wrote about on Monday, are those that companies can easily draw upon to pay debt, acquire companies, or give dividends to shareholders. On the other hand, the rest of the assets on the balance sheet aren’t so liquid, but they can be even more important.

Property, plant, and equipment

Most often, these items are the materials and factories that the company needs to make whatever it sells. So if, say, GM owned an auto plant that it used to make trucks, it would carry the cost to build the factory on its balance sheet. Over time, as the factory churns out more trucks, the equipment starts to wear out, and so GM will deduct a little bit of value from this asset every year (this process is known as depreciation).

As the factory depreciates, you can start to anticipate when the company will need to lay out a ton of cash (or borrow a ton of money) to buy a new factory.

But unfortunately, for too many companies, new factories have to be built long before the old ones completely wear out, simply because the company needs to keep up with competitors.

Take a company like Coca-Cola, whose formula hasn’t changed much in decades. Although Coca-Cola could make improvements to its factories to find new cost efficiencies, it doesn’t have to. The Coke you drink today is about the same Coke you drank in 1999.

On the other hand, a company like GM, whose inventory needs to constantly change to keep up with other car companies, will need to retool is factories all the time. I’m not an expert on car manufacturing, but I imagine hybrids require equipment that’s a lot different from plain-old gas guzzlers.

So keep those kinds of competitive advantages in mind when assessing the true value of equipment and property.

Goodwill

Goodwill can be confusing for a lot of investors (including me). When one company buys another company, any excess that the purchasing company paid over the target’s book value is considered to be goodwill.

Let’s say Dino’s Burger Hut has $10 million in tangible assets. Joe of Joe’s Shake Shack decides to buy Dino’s Burger Hut for $20 million, because he recognizes that the Burger Hut’s ongoing profitability is worth more than the assets alone. So Joe puts $10 million in goodwill on his balance sheet.

Companies can adjust the goodwill downward if the business that it purchased has depreciated in value for some reason. You can look at increases in goodwill for evidence that a company is making acquisitions. But when adding up how much a company’s assets will protect you when you buy its bond or stock, always remember that unlike other assets, you can’t sell goodwill.

For a lot more great information about goodwill, take a look at this article.

Intangible Assets

Intangible assets are basically all of those things that you can’t physically touch that make a company valuable: Things such as copyrights, patents, trademarks, brand names, and franchise power. When one company buys another, it can carry the value of those assets at their fair value.

Although they used to be able to, companies can’t carry intangible assets on their balance sheet that they developed in-house. So if Coca-Cola came up with a brilliant new drink formula, it couldn’t simply attach a value to that asset on its balance sheet. But if it acquired a company with the formula, it could. Coke also can’t attach a value to its brand (although very valuable) and carry it as an asset.

Long-term investments

Long-term investments, like stocks and bonds, are valued on the balance sheet at the current market price or at cost, whichever is lower. So even if the market price of the asset has gone up considerably, that won’t be reflected in the balance sheet. That kind of improvement won’t be recorded until the company sells the investment.

For some companies (Warren Buffett’s Berkshire Hathaway for example), the value of the investments is often the greatest asset a company has.

Long-Term Assets + Current Assets = Total assets

I’ll write later on the different ways assets can be compared to earnings to measure a company’s efficiency. But that’s enough to absorb for now. If you want further reading before tomorrow, I recommend checking out Warren Buffett and the Interpretation of Financial Statements by Mary Buffett and David Clark. It’s an easy read meant for beginning investors, and I used it myself to double check a lot of this material. Don’t buy it thinking you’ll get some sort of revelation into the way Buffett works. It’s more of an introduction to investing.

On Friday, I’m writing about company liabilities.

— Joe Light

I’m out of the country on vacation all this week (To Spain, thanks for asking!). But rather than leave you with nothing, I’m going to take this blog back to basics again, with an introduction to company balance sheets. Even if you’re a seasoned investor, it helps to be reminded of the earnings statement’s less-favored brother. I hope you pick up a few new things along the way.

A few weeks ago, I gave a basic intro to value investing and tackled the price-to-earnings ratio (P/E), one of the most used measures pulled from a company’s income statement.

For the next several days, I’m going to address the balance sheet, which is just as important. A company could earn $100 million per year in revenues but still go bankrupt if it carries too much debt. The balance sheet can also reveal the value a company carries even if it faces depressed earnings.

Here’s the lineup: Today I’ll introduce the balance sheet and talk about current assets.

On Wednesday, I’ll talk about the rest of the asset side of the balance sheet.

On Friday, it’s on to a company’s debts.

And a week from today, I’ll sum it all up and show some of the other ways it can expose problems or advantages that a company has.
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A primer and a few definitions

Unlike the income statement, which records gains and losses throughout a year or quarter, the balance sheet is a snapshot in time. The balance sheet is a window into what assets and liabilities the company carries at the exact moment that the company drew it up.

You can divide the balance sheet into two parts: a company’s assets, which include cash, receivables, inventory and equipment; and a company’s liabilities and shareholder equity.

Within the liabilities category is “Current Liabilities”, which is debt due within a year, and “Long-Term Liabilities,” which is not.

The shareholder equity of a company, which is the same as net worth, is the total amount of liabilities minus the total debt.

Analyzing the company’s assets

When you begin to look at a balance sheet, it’s good to tackle the assets in two main segments: current assets, and everything else.

Current assets are a company’s most liquid assets and include cash, accounts receivable (i.e. money soon to be paid to the company), and inventory. It helps to think of the current assets line-up as a chain: inventory becomes accounts receivable, accounts receivable becomes cash.

Cash: More is better (duh). But it’s also important to remember that companies with huge piles of cash didn’t always accumulate them from ongoing business. Cash hoards can appear after the sale of a business segment or the issuance of bonds.

If you’re not sure how the company earned the cash it has, you can always look at the last few years of cash balances to see if it accumulated gradually or suddenly. The debt portion of a company’s balance sheet, which we’ll look at on Wednesday, will also reveal if it has issued bonds.

Companies can use cash in several ways. It can be reinvested into the business, used to pay down debt, to give back to investors in the form of stock buybacks or dividends, or to acquire other businesses. Some companies simply like to carry a lot of cash as a kind of emergency fund in case of a rainy day.

Net receivables: Many companies don’t collect payment immediately after selling a product. Instead, the customer will have a certain number of months to pay. Until the customer does, the money is considered a receivable. Of course, some customers will renege on their payment, and for balance sheet purposes, the company estimates how much will never be collected and deducts it from the receivables figure.

Inventory: Inventory is all the goods that a company has already manufactured for sale but that haven’t been sold yet. By itself, it doesn’t tell you much, but look at how the inventory has changed over time, and you can learn how a company is faring.

If earnings are consistently increasing and inventory correspondingly goes up, it means the company is expecting increased demand for its products and has increased manufacturing to keep up. If earnings went up but the inventory went down, it could mean that the company is expecting a drop in business, which could either be because of its own problems or simply because its industry is cyclical. For some companies, like those in the tech business, carrying a lot of inventory is dangerous, because the product could become obsolete.

Other current assets: In most cases, these don’t tell you a ton about a company’s ongoing business but they’re useful to know. They could include prepaid expenses or deferred income tax refunds.

Add all of those components up, and you should get the “Total Current Assets” figure that a company puts on its balance sheet.

On Wednesday, come back to learn about the other assets that a company could have and how you should consider them.

— Joe Light

Hi guys,

For today and all of next week, I’m on vacation in Spain. I don’t think I’ll have access to a computer while I’m gone. Next week’s posting schedule won’t be every day as it normally is. Instead, you’ll get posts on Monday, Wednesday, and Friday. I hope you enjoy them and forgive me for not responding to questions or moderating comments before I get back on Monday, June 8.

Enjoy the week.

— Joe Light

A study from the Urban Institute came out a couple weeks ago analyzing how the stock market crash of 2007 and 2008 will hurt baby boomers’ retirement income.

They looked at three possible recovery scenarios: 1) No recovery - The market simply grows at its historical pace. 2) Full recovery - The market grows at a rapid pace and in 10 years hits the point that it would have had there not been a crash. and 3) Partial recovery - In 10 years, the market hits a point halfway between scenario 1 and 2.

You could argue that all three scenarios are optimistic. A lot of economists and experienced investors are saying that our growth rate going forward will actually be slower than the historic average. So the “No recovery” scenario might even be growing the market too fast.

But the study is good if for no other reason than to show that if you have more than a decade to retirement, you really don’t have to panic about this crash.

The study looked at three groups of baby boomers: pre-boomers (born between 1941 and 1945), middle boomers (1951 to 1955) and late boomers (1961 to 1965).

For late boomers, they found that retirement income for the average household would decrease 7.2% under the no recover scenario, but increase 3.2% under the full recovery scenario because of the crash. Remember that the “full recovery” scenario is a probably implausible rapid return to the pre-crash highs.

Pre-boomers lose money in all circumstances, shedding 8.5% of retirement income with no recover and 6.9% under a full recovery.

They also found that those high on the socioeconomic ladder were much more heavily affected because they tended to have more money invested. Middle boomers, for example, would lose 14% of their retirement income due to the crash under the no recovery scenario.

Anyway, the study slices the data many different ways. It’s decidedly optimistic, but for all you people under 30, seeing that even some boomers might actually come out ahead if optimism prevails has got to be heartening.

— Joe Light

In case you missed the news, most economists think the recession will end somewhere around the middle of this year. That doesn’t mean everything will go back immediately to how it was before the crash. They think growth will be slow, and unemployment won’t peak (at 10%) until next year.

I hope you haven’t kept your money out of the stock market until now, waiting for such a report. Because if they’re right, we’ve probably already experienced the market bottom and a huge percentage of the new bull market’s gains have already happened.

According to Ned Davis Research, market bottoms happen about 4 months before recessions end on average. Of course, history doesn’t have to repeat itself, but if economists are right and the recession will end in the year’s second half, that S&P 500 low in March (about 35% ago) was as low as the market is going to get.

Hopefully you haven’t been trying to time the market anyway and have kept your asset allocation pretty consistent throughout this whole mess. But if you need even more reasons to not wait around for someone to wave a green flag announcing the recession’s end, take a look at this list of press releases from the National Bureau of Economic Research. Scroll about halfway down the page.

Do you see what I’m seeing? It took the NBER between six months and two years to announce the official end dates of previous recessions and expansions. In fact, in November 2001, when the NBER announced that the recession had begun that previous March, the recession had actually already ended, though NBER wouldn’t make that determination until July 2003!

This is a short post, but it almost feels like too many words to explain one, easy lesson: Market timing is hard, if not impossible. The stock market tends to lead every leading indicator out there. So unless you want to make a fulltime job out of stock watching (and even professionals screw up all the time), you’re best off sticking to an allocation based on your own needs and goals rather than based on the news of the moment.

— Joe Light

Municipal bonds are often written about as if they’re as safe as Treasury bonds. As long as U.S. debt is denominated in dollars, the Treasury Department isn’t going to default on its debt (I mean, I suppose it could, but why?). On the other hand, the states and cities that issue municipal bonds can’t print money but they can tax the hell out of their constituents to pay debt off.

That’s led municipalities to have extremely low default rates. In fact, before the crisis hit its peak, single-A rated munis had a historical default rate of 0.0084%, which is 80 times lower than the historical default rate of AAA-rated corporate bonds.

California is one state facing serious budget difficulties.

Of course, that was before tax revenues fell through the floor. Now, states and cities want access to the same bailout money used to help banks. Congressmen have already written legislation to specifically help those cities that lost a lot of money making investments in Lehman Bros. debt. (Seriously? Cities were investing in Lehman Brothers?)

Of course, as an investor just looking to grow his money safely, you’re just wondering whether investing in your local muni bond is worth the risk of default. Here’s what I would consider.

What do you get for the risk?

The absolute safest investment you can make is one in a U.S. Treasury bond. So when considering a muni, the first and easiest thing to check is how much extra the muni will pay you for taking on additional risk.

Municipal bond rates will vary by municipality, but according to Bloomberg, the average, 5-year Treasury bond has a yield of 2.19%. The average 5-year muni bond’s yield is 1.82%. But because muni interest isn’t taxed by the Feds (and if you buy one from your own state, in most cases you avoid state taxes), the effective yield is 2.53%, assuming it would have been taxed at 28% otherwise.

Step one complete…for taking on the risk that a city or state defaults, you earn an extra 0.34% of yield for the average 5-year muni bond.

What is keeping a city or state from defaulting?

The main reason investors have long assumed states and cities won’t default is the one we’ve already addressed: The ability to tax. If a city had a $100 million bond payment coming up and didn’t have the money, it could simply raise $100 million in taxes by adding a temporary…I don’t know…marshmallow tax on anyone who wanted to make s’mores for the next 12 months.

Cities and states also don’t want to default because it seriously crimps their ability to raise capital later on. What investor wants to lend money to a city that recently defaulted? If a city did default, investors would demand much higher interest rates later on to make up for the risk, something that could hurt a city for decades.

Those reasons for not defaulting were pretty strong when cities and states faced their individual budget difficulties. But since the recession is making dozens of cities stare default in the face, the stigma of defaulting could disappear quick. (”Hey, everybody’s doing it!”) The question becomes: Are politicians more loathe to raise taxes in a recession or to shaft investors, many of whom their constituents are already angry at?

Warren Buffett recently said as much, though he was referring to muni bonds protected by insurance companies.

But finally, there’s this federal backstop that may or may not exist. Every state’s senators and representatives don’t want to see their hometowns go into bankruptcy. So they could offer up the seemingly unlimited coffers of the Federal Government to save them, and by extension, the poor saps who bought their muni bonds.

All of these reasons that things could be more or less dangerous are pretty hard to measure. And right now, the market seems to think that on the whole, the muni market is not nearly as dangerous as it was six months ago. Still, I don’t know if I’d run out and buy California general obligation bonds.

So what to do?

Although it’s not clear who, if anyone, is not going to make it out of this mess with their solvency, you don’t have to make a bet on any one government. There are plenty of mutual funds out there that will diversify you across muni bonds.

Take a look at this list of Fidelity muni bond funds for many states. I picked Fidelity at random. Any number of fund companies offer these.

If your state doesn’t give you a state tax break, you can also look at national muni bond funds (Since I’m already at their site, here’s Fidelity again.)

These options give you diversification across governments, which should cut down on some of your worries. No, it’s not a guarantee. Treasury bonds are still safer. But if you don’t have a ton of money to diversify with individual bonds, it’s better than staking a huge sum of money on one city’s fortunes.

— Joe Light

Last week, a Wall Street Journal columnist wondered if managed futures were really a healthy contribution to a diversified portfolio.

This week, absolute return mutual funds are under the microscope.

Absolute return funds are mutual funds in which the mutual fund manager can invest in or sell short nearly anything he wants. If he thinks U.S. stocks are primed for an upswing, he can buy U.S. stocks. If he thinks the Euro will surge against the U.S. dollar, he can invest in Euros.

That’s a big difference from the relatively tight boxes that normal mutual funds are stuck into. Most of the time, managers are limited to picking the best companies within, say, the U.S. mid-cap growth category. Because absolute return managers can bet against the market just as easily as they can bet with it, they’re supposed to make money whether the market is rising or falling.

Some mutual fund companies think that absolute return funds are the next big thing in their industry. I know of at least five that have launched over the last couple years and have spoken to a couple mutual fund managers who plan to launch them.

It’s a concept similar to one I discussed last month, and comes down to the same, fundamental question: Who should determine your asset allocation: You or an expert?

The Wall Street Journal columnist comes down somewhere in the middle, writing “The right absolute return fund can make a great addition to a balanced portfolio.” Despite that statement almost being a tautology (Just avoid the “wrong” absolute return funds, and you’ll be fine), I’m not sure I agree with the writer on what their role should be.

To me, “diversification” means diversification between assets. So even when one asset does poorly, another one can pick up the slack or at least do less poorly.

Investing in an absolute return fund, on the other hand, diversifies your investment styles. If you put 10% of your money in a total return fund and invest the rest yourself in your usual mix of index funds, your portfolio really now has two money managers setting your asset allocation: You, and the guy you gave 10% to.

There’s nothing inherent in the absolute return fund that should make it “zig” when others “zag” as the WSJ headline asserts. The manager could very well pick the exact same allocation that you had chosen. Instead, it seems like you’re completely at the mercy of how good the manager is at his job. Since so few of these funds have any sort of track record, I don’t think I’d be the first one to hop on the bandwagon.

— Joe Light

If you’re coming from the Carnival of Personal Finance at Greener Pastures, welcome! I hope you enjoy this post.

Invest Wisdom is all about helping ordinary people invest better. You’ll find that my take on many investment issues is quite different from your typical PF blog. Look in the right-hand sidebar to see some other things I’ve written recently. And please subscribe if you like what you see.

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Since starting this blog, I’ve paid more attention to other personal finance blogs around the web. Recently, I watched a back and forth about whether debt reduction requires laser-like focus or a more flexible approach. As I read the writers’ personal stories of empowerment and triumph, it occured to me how different most personal finance issues are from the process of investing.

You see, I don’t think of this as an empowerment blog. This stuff is about as far from motivational as you can get. But empowerment does have a place in most personal finance issues. A guy with $10,000 in revolving balances on his credit cards knows that he should spend less money (or earn more) to pay the debt down. He just needs a good kick in the pants or pat on the back to get the process started and keep him focused.

That’s why commenters like Suze Orman are so effective at what they do. They use motivators like “Why do you do this to yourself?” or “You’re better than this!” to either scare someone from a mistake or empower them to action.

But when I hear people using the same emotion-laden words to address economic or investment issues, I start to feel a little queasy. Today, Clark Howard, an author and personal finance radio host, published a piece about the rising dominance of China as an economic power. He noted our indebtedness to the superpower and compared fears that we’ll become subservient to them to the fears that Japan was going to take over in the 1980s. His conclusion: “But we will be fine because we have something they don’t have: We have freedom. And the power of that freedom is unbelievable. To do what you want, say what you want, live where you want.”

Call me crazy, but I don’t think freedom is going to repay trillions of dollars of debt to the Chinese or shift our economy from one that buys things from importers to one that makes things to sell to the rest of the world. (In context of the story, he doesn’t mean free markets—this is more your freedom of speech, I’m-proud-to-be-an-American kind of freedom.)

My favorite emotion for an investor or an economist is this: nothing. When I invest, I don’t want to feel good about a decision. I don’t want to be afraid of a decision, frustrated at a decision, and certainly not excited at a decision. I want to be about as dispassionate as I can possibly be and use only objective criteria in making the decision.

I’m convinced that this is why most people are lousy investors. We got emotionally excited about stocks and lost 41% last year. We became fearful of stocks and missed the recent 35% run up.

In short, the same inspirational talk that got you to take the major, positive steps to pay off debt, start 401(k) contributions, and open a Roth IRA will inspire you right into making poor investment decisions if you’re not careful.

This is why passive investing is the right choice for most people, even though it might not be the best choice that could be made if, like Data from Star Trek, we could just turn our emotion-chips off. (Sorry for the dorky Star Trek reference.) According to a recent study, investors lost 7 percentage points of annual return over the last 20 years by entering and leaving the market at inopportune times.

If you have trouble keeping your emotions in check, the best investing decision you’ll ever make will be to make as few decisions as possible. Set up automatic investments for your 401(k) and IRAs, set an allocation between stock and bond index funds once a year, and pay attention to your investments as little as possible. Yeah, I’m getting a little tired of writing and reading that same old advice. But it’s more prudent than “inspiring” you to make active investment decisions.

— Joe Light

Today brought the news that the “fear index” has fallen to its lowest level since Lehman Bros. went under. The CBOE Volatility Index (a.k.a. the VIX) technically measures the market’s expectation of nearterm market volatility. Basically, it measures how jittery investors are about rapid drops in market price.

Are investors no longer afraid of the market?

At its height, soon after Lehman’s bankruptcy, the VIX stood above 90. Now, it’s at about 28.75.

Some investors see this as a good sign that the worst is over. But for me, it recalls an old Warren Buffett maxim: “Be fearful when others are greedy, and be greedy when others are fearful.”

So now that stocks are up more than 35% from their low, investors are starting to feel much better. That would seem to suggest that the “deals” to be had in the market are rapidly disappearing. Still, at about 30, the index is well above the 10 to 20 range we saw in the five years before the crash.

A few people in a CNNMoney story on the subject seem to agree. Says a chief investment strategist quoted in the story: “A low VIX isn’t necessarily a positive. It could mean that people are getting comfortable and that might set us up to more shocks in the system. Investors might not be factoring bad news into the equation.” Several others quoted in the story said that they aren’t concerned as long as investors’ optimism continues to be backed up by good news.

I have enough trouble figuring out what’s going on in the heads of my friends and family members. So I’d never make a decision based on what I think all the minds of the market added together are feeling.

But if you’re a value investor looking for places to put your money, you’ve gotta wonder in the back of your mind if a drop in investors’ fear is really good or bad.

— Joe Light