Identifying Financial Strength with a Strong Balance Sheet

stride-identifying-financial-strength-with-a-strong-balance-sheet-2-featured.jpgAs value investors, identifying strong companies is the first piece of the puzzle. A strong balance sheet indicates that a company is in good financial standing for longevity and growth, but how exactly do you identify that? This webinar delves into the particular approach we use at STRIDE.

Value investors use varying methods of identifying financial strength for companies that they're interested in. At STRIDE, our financial Strength metric is heavily focused on identifying a strong balance sheet with various ratios and formulae. This webinar below outlines both our 3D Value Investing scoring approach, as well as delving into the specifics of how we score Strength when valuating target companies. 

Identifying Financial Strength: How We Use the Balance Sheet as an Indicator

Wistia video thumbnail - The importance of balance sheet strength

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The following are transcript points taken from the above video on valuating companies' Strength scores according to STRIDE's 3D Value Investing scoring system. 

How We Use the Balance Sheet as a Financial Strength Indicator

This week we’re going to focus on 3D Value Investing. In fact, we’re embarking upon a series in the upcoming weeks that will explore 3D Value Investing.

We’ll start by looking at what 3D Value Investing (3D VI) is, and focusing on the first of our fundamental scores: Strength. We’ll explore the measurement of Strength, its distribution in our database, whether or not it works, and what happens when we add other STRIDE scores to balance this score out.

What is 3D Value Investing?

First off, we do have an in-depth eBook that explores and explains the 3D Value Investing approach, which I recommend reading should you be interested in understanding how STRIDE works for value investors.

3D VI is the culmination of fundamental analysis (which is the core of our 3D VI model), valuation, and timing.

  1. Fundamental analysis

Our fundamental analysis is made up of critical thinking and scores supported by proven financial ratios. In any situation, we’ll look at:

  • Is this a good business?
  • Is it well run?
  • S (Strength), R (Returns), I (Intrinsic Value), D (Dividends), and E (Earnings Predictability) scores.
  1. Valuation

Valuation tells us what a share is worth, and what we should pay for it. We look at:

  • What is the share worth?
  • What should we pay?
  • Fair value and considered buy and sell scores.
  1. Timing

Timing really tells us what the market sentiment is, and when our action is required. This is important, because we want to make sure that a particular investment is sound, but is also undervalued when we enter. We look at:

  • Market sentiment.
  • Movement (of the price).
  • T (Timing) score.

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Now, while we are looking at the results and process of an individual score in this webinar, you shouldn’t use any of these scores individually to valuate a company as a target investment. These scores rely on each other and have an interplay that is vital to the strength of your stock evaluation.

How We Measure Financial Strength

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We measure Strength for businesses in three main buckets: Financial services (banks, asset management, capital market businesses, and custodian type businesses), Insurance, and Standard.

Two notes to mention from the above table explaining our approach in each of the three measurement buckets:

  1. We look for a T1 Capital Ratio that’s  above 12% (twice what Basel III recommends)
  2. For Standard businesses, we always apply customised balances of scores depending on the industry sector of the business (we wouldn’t look at an airline the same way that we’d look at a manufacturing business, as an example).

Hopefully, that gives you a good idea of how we measure, so now let’s look into the distribution.

The Distribution of Strength in our Database

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What we can see here is that of the 50,000 or so businesses that we analyse on a daily basis in the STRIDE database, most businesses fall into the 70 and below category, and more than half fall into the 50 and below category.

This is why our STRIDE 3D VI target list looks for businesses that are 80 and above, to highlight the strong businesses in our database. Although, you will also see that businesses which are 60 and above can make your target list (but that is at the individual investor’s discretion, and depending on what they’re looking for).

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What’s interesting is that of the businesses in our database that have filed for bankruptcy in the last three years, the vast majority of these fall below 80, and even in fact below 60. This shows the STRIDE 3D VI Strength score working to our advantage, by setting aside the businesses that are likely to have longevity.

What’s fascinating here is that while six businesses filed bankruptcy in the 70 category, if we look back to the previous slide, you’ll notice this is out of 6,500 businesses. Less than 0,1% of businesses. As opposed to the 10 category, where 17 of 3,500 companies filed bankruptcy… which clearly shows that the rate of failure is much higher the lower the STRIDE strength score is.

What we can also see is that there is always a risk of failure in investing, and no investing methodology should tell you otherwise. Investing is never 100% certain - instead it’s a leveraged risk. Even in our STRIDE Strength score of 100, there were 2 failures within 3 years. Yes, that’s a very low percentage of failure… but it’s there, which is why we don’t only rely on one score to evaluate a company with.

One final thing that I find interesting to look at here is: Acquisitions.

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What I find interesting is that we see this huge split between the lowest decile and the highest: 119 acquisitions at Strength score of 10 versus 14 at a Strength score of 100. Now, if we look at distribution, we’ll notice that there are 3,500 businesses with a score of 10, and 2,500 businesses with a score of 100. But there are also 17 failures at the score of 10, and only 2 failures at the score of 2. So, why are there so many acquisitions at financially weak companies that might be going bankrupt? I believe this is to do with distressed sales - something that might not be picked up with a quick glance of only acquisitions. These businesses get to a point where they have to sell, or get aggressively purchased, which is also the reason the acquisition number is so low with a score of 100 (because these businesses know that they can stand on their own two feet).

Balancing Financial Strength with Other Scores and Dimensions

Now, if we add in our other STRIDE scores to balance out the businesses who have a Strength score of 80 and above, we see something like this.

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When we balance with a Returns score of 60 or above, our list of bankruptcies drops from 11 to 3 immediately. If we add Intrinsic Value score of 20 or above, it doesn’t change much (drops to 10). But if we add the Dividend or Earnings Predictability scores of 60 and above, the failures altogether disappear.

I’ll go into each of these other scores in my following webinars, but what’s important to see is that they do balance each other out and support each other, while all maintaining a unique value.

Now, if we added other dimensions (timing and valuation) to this financial strength evaluation, we’d see something interesting too.

Screen Shot 2017-03-29 at 12.45.54.png

If we include a Timing score of 60 or above, we eliminate 6 bankruptcies and end up with 5. If we include Valuation, we eliminate 8 bankruptcies and end up with 3. However, if we add the 3 dimensions (not with all STRIDE scores, but only with the Strength score), we end up with 0 bankruptcies too.

In Conclusion

The STRIDE Strength score clearly eliminates weakness, although it’s not a silver bullet and investment always carries risk. However, that’s why we’ve come up with a multi-dimensional evaluation methodology, because good investment always requires multiple lenses. If you’d like to have me run you through our platform and how it can benefit your portfolio strategy, click below to schedule a free live demo with me.

Topics: Valuation, 3D Value Investing


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