This is a question I’m receiving a lot lately and, frankly, a question worth pondering. I’ve never read about anyone who consistently (time and time again) has correctly predicted the end of bull or bear markets, or even consistently predicted the timing of temporary market corrections. Far be it from me to attempt to do so. Many people got out of the stock market near the lows of late 2008 and early 2009 and have missed one of the largest market increases since then in the history of the stock market. Emotions tend to make investors “react” and thereby “act” at just the wrong times.
If you’ve read my book, Choose Stocks Wisely, or even just read posts on my blog, you surely know that I’m very keen on the financial information provided by the corporate balance sheet relative to what it offers toward proper risk analysis. Given this balance sheet emphasis, there are some things I’m seeing in the current stock market environment that give me pause. For example, I’m noting a lot of small company stocks that are simply “flying” on unachievable future prospects while the underlying balance sheets are extremely unhealthy. By the term “unhealthy,” I mean balance sheets that are heavily levered (burdened by excessive debt) and lacking the necessary net working capital (current assets less current liabilities) to maintain existing operations, much less to rapidly grow their operations.
The ongoing low interest rate environment has been a boon to the stock market. People realizing less than a single percentage point of interest on certificates of deposits (CDs), for example, have become first-time purchasers of stocks in hopes of achieving a better return. Corporations have been able to cheaply lever profits through borrowing at historically low interest rates, thereby punctuating the appearance of attractive earnings. Of course, shareholders love earnings.
An irony is that when the market is going gangbusters, we, as investors, can get lulled into forgetting about the heightened dangers of excessive risk-taking. At a time when the balance sheet should be all the more important to us before investing in stocks because of the market’s stronger appetite for risk, this financial statement is often more strangely absent from investing conversation as people start to believe in the certainty of ever-expanding future company profits. However, it remains that the only financial report that is intended to tell us about the present quality and amount of company equity is the corporate balance sheet. Yes, when confidence is peaking, stock prices can race miles past the fundamental equity value expressed by the balance sheet.
So, while I really have no idea what the stock market will do tomorrow or the day after that, I do know that it has its cycles. Since I can’t accurately predict those cycles to choose the best times to enter and exit the stock market, I’ve found proper risk assessment by careful balance sheet analysis to be the best approach to stock investing, regardless of “when” I invest.
I will add this addendum. When I note more and more stock prices getting miles ahead of balance sheet fundamentals (metrics), it indeed makes me ponder more the issue of whether the market has gotten ahead of itself. I use the balance sheet to identify quality stocks trading at low prices. Intuitively, these stocks will be harder to come by when the market is booming and more prevalent when euphoria abates. It really is hard to overstate the incredible information worth of the balance sheet.
Dear Dr. Allen’ Thank you for your current post. In it you state, “I’m noting a lot of small company stocks that are simply “flying” on unachievable future prospects while the underlying balance sheets are extremely unhealthy.”
How do you determine that the future prospects of a company are unachievable? What process do you follow to determine that “a lot” of small company stocks are affected? Thank you for sharing your insights. I enjoyed your book and will be rereading it.
David
Hey David,
When a company is generating significant operating losses and its balance sheet does not reflect the financial flexibility to achieve profitability (i.e. inadequate liquidity and/or inadequate solvency), how can the company’s future be attainable? I use the balance sheet to evaluate the ability of a company to sustain future operations; so do auditing firms who often issue a going concern warning, in such cases, in the financial filings to the SEC.I’m providing a finviz screen example for checking out small companies that are experiencing recent strong stock returns but which have had poor operating results of late, and are trading above the book value of the company equity.
http://finviz.com/screener.ashx?v=111&f=cap_small,fa_pb_o1,fa_roa_veryneg,fa_roe_veryneg,ta_perf_13w30o&ft=4
Thanks, David.
Paul
DOC- I agree with your assessment . Fundamentals don’t justify current stock prices but I , like you, don’t know when the music stops ,so lets stay disciplined.
Dr. Allen, Thank you for the screen example.
You are welcome, David.