2 stocks with rock-solid balance sheets

It’s a tug-of-war. Aussie corporates table their half-yearly earnings reports, as they’re legally obligated to do. And investors (and the financial press) try to make sense of it. We see it every earnings season.

In this series, I speak to a couple of Aussie equity fund managers about how they read company earnings reports. I quiz them about the numbers they pay most attention to, the utility of metrics like EBITDA, and the red flags to watch for.

In the first part below, I ask them each to discuss a stock that ticks their “pristine balance sheet” box. And crucially, they also explain whether this necessarily means you should own the company.

Read on for insights on how to cut through the spin as the first half of fiscal 2022 draws to a close.

A2 Milk: From darling to dog

Jared Pohl, co-founder and director of ECP Asset Management, singles out a well-known consumer staple producer when asked to name a stock with a strong balance sheet. And it’s a surprising pick because, in the space of around 18 months, A2 Milk (ASX: A2M) has gone from a darling of the ASX to a dog, its share price falling more than 50% in 2021. It even made it onto Atlas Fund Management CIO Hugh Dive's annual Dogs of the ASX compilation. 

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Dogs of the ASX in 2021

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“It’s a company that we don’t own anymore, but A2M has a strong balance sheet. At the full year 2021 result, the company had:

• $875 million of cash in the bank,
• total assets of $1.3 billion,
• total liabilities of $288 million, and
• equity of $1,08 billion, of which $1,04 billion is attributable to retained earnings."

“Not only is the balance sheet clean, but the income statement and the cash flow statements are simple to understand as well,” Pohl says.

Overall, he regards the company as a very well run business that has performed exceptionally well since it was founded in New Zealand in 2000.

If A2M is so good, why doesn’t Pohl still own it?

“The reason that we exited our position was that our initial investment hypothesis was starting to break down,” he says.

“Despite the fact that the business was in a solid financial position, the evidence we were seeing started to test our investment thesis that A2M would be able to gain and maintain a 10% market share of the Infant Milk Formula market in China both online and in-store.”

In particular, Pohl calls out the rising competitive threat from brands in China, the company’s overflowing inventory of stock as a result of COVID pressure and the departure of key management team members.

“While A2M always maintained a strong balance sheet, inventory dynamics on the balance sheet significantly changed, impacting the company’s profitability and risking its long term competitive advantage,” he says.

More than the sum of its parts

The price of a stock is always more volatile than what the stock is actually worth, explains Pohl. In a nutshell, investing is about accurately forecasting the future value of a listed company, buying its stock at a discount, and selling it when it reaches – or exceeds – that value.

“In this instance, given the breakdown in the assumptions of our investment thesis, we were unable to have enough confidence around the actual future value of the business, and so we had to exit our position,” Pohl says.

Why accountants don’t have the investing game sewn up

One of the standout comments from my chat with Leithner & Co’s Chris Leithner is a neat summation of why the best investing isn’t all about maths.

“If investing was nothing but accounting, accountants would make the best investors. But they don’t because it isn’t,” he says.

The stock he nominates as one with a particularly strong balance sheet is Platinum Asset Management (ASX: PTM), which ranks among Australia’s largest global equity managers. Though it’s been overshadowed by competitor Magellan Financial Group (ASX: MFG) in the last five-plus years, the troubles plaguing Hamish Douglass’s global funds could ultimately reverse this.

“The accounts of Platinum are straightforward because the business is transparent. An astonishing percentage of its top-line revenue falls to its net profit after tax, it’s debt-free and doesn’t need debt to grow because it is so scalable,” says Leithner.

“For example, managing $30 billion of funds isn’t going to cost you any more in terms of labour than managing $10 billion.”

Though he regards the accounts as pristine and quite “straightforward,” he says determining an appropriate valuation for such a company is not simple. Accurately determining its worth requires consideration of whether the falls in funds under management over recent years will continue or recover, and when.

“The key thing is, if you’re going to own Platinum – which we do – that any equity analysis is based on accounting but it’s not the sum total,” Leithner says.

Asked why he chose Platinum over Magellan as his preferred locally-listed global equities manager, Leithner says the decision hinges on several factors.

“It’s the age-old story of if you don’t understand something, stay away from it,” he says. But relative scepticism about Magellan being very heavy in the FAANG stocks – though they rode the wave extremely well – was also a big part of the decision.

“Things like Netflix cratering 10% to 15% overnight isn’t going to do Magellan a world of good, since the streaming platform is a big holding of theirs,” Leithner says.

“The most general point is understanding not just the accounts of a business but also the operations that the accounts are describing.”

Necessary but not enough

From the above responses, it appears that a solid balance sheet is a must-have attribute for stocks worth owning but it’s not a silver bullet. This is useful to bear in mind as we prepare for the half-yearly bombardment of sales figures, underlying profit results, EBITDA numbers, liabilities and more. 

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