The financial meltdown has shown yet again why solid balance sheets are so important. This screen can find firms that have them.
As we've all noticed, financial markets are subject to shocks--shocks of such magnitude that common financial models suggest they are virtually impossible. For the equity investor, these shocks reinforce the importance of focusing on companies with solid balance sheets. Companies that rely little on short- or long-term debt are those most likely to survive the kind of severe recession and credit crunch we're currently living through.
Why is leverage so deadly? For a company with $10 billion in assets supported by only $500 million in equity--a leverage ratio of 20 to 1--it only takes a 5% decline in the value of assets to wipe out its entire equity base, leaving it insolvent. Plus, when credit markets freeze up because investors are wary of supplying capital, refinancing debt can become problematic. By taking on debt, a company forfeits some control over its own destiny.
The focus of this screen is to find companies with the balance-sheet strength to make it through this mess. To help us do this, we turn to the Morningstar Financial Health Grade, which we recently retooled. The new algorithm is a huge improvement over the older version, both in terms of methodology (better) and the number of companies graded (more). Most important, if you and your clients are looking for bargains in this bear market, the financial health grade is a good quality screen to use along with your valuation criteria.
The idea behind the new financial health grade is to show at a glance how much cushion a company has before it starts running into financial difficulties. The grade compares a company's enterprise value--the sum of its equity and debt capital--with its total liabilities. By examining the historical volatility of enterprise value, we can estimate the likelihood that enterprise value falls below the company's liabilities at some point in the future. If this were to happen, default is expected to occur, the equity is worthless, and the firm is turned over to its creditors. That's bad. The financial health grade uses option-pricing algorithms and probability distributions to estimate the likelihood of such an event. The greater the likelihood, the worse the grade.
The financial health grade is automated-- there's no analyst input. While this means the grade will miss some company-specific idiosyncrasies, it also means we can grade most every company in Morningstar's database. Currently more than 8,000 stocks receive a financial health grade. And so far the results are encouraging. Of the stocks that dropped more than 80% during the June-October time frame, two thirds of them earned financial health grades of D or F.
To begin the screen, we'll require a financial health grade of A. Roughly 10% of Morningstar's universe receives an A grade.
Financial Health Grade >= A-
Let's narrow our list by focusing on companies with decent growth and profitability. We can use Morningstar's growth and profitability grades, which we also retooled within the past year to make them more robust. The growth grade measures how rapidly a company has been able to increase its revenues over the past five years. For the purposes of this screen, we're not so much looking for blow-out growth numbers as looking to eliminate firms that may be in secular decline or stagnation. The profitability grade measures how high and steady a company's return on equity has been over the past five years.