Strong Balance Sheets
A Strong Energy Stock
I used to tell my son hitting a baseball correctly is all about
balance. The same is true in investing; to invest correctly you
need to balance
risk and return.
When I worked at Texaco, "protect the balance sheet" was our
rallying cry. The goal was to never over-lever the balance sheet
with debt, because a strong balance sheet would get you through the
Now, when I teach, I harangue my graduate students over and over:
Finance is a function of balancing risk and return.
(Hopefully they can hold that thought after the semester ends!)
Kidding aside, I never cease to be amazed at how seldom people
focus on the downside risk to their investments. Mesmerized by the
allure of greater financial gains, people believe they can achieve
high returns combined with low risk. In all my years in the
business, I have yet to see that financial phenomenon occur.
In particular, investors time and time again fail to give ample
weighting to "financial" or default risk arising from increasing
leverage. Indeed, if you don't believe in credit risk, just look
across the Atlantic at Europe or remember Long-Term Capital
Management or the housing collapse of 2008.
Leveraging your investment may magnify your returns as long as the
investment heads north. However, if it turns sour the higher
interest expense will be harder to cover, and default may be
knocking at your door.
Excessive debt - whether public, company or individual - eventually
reduces growth, and if left unchecked, will lead to bankruptcy.
In their recent seminal work, Professors Carmen M. Reinhart and
Kenneth S. Rogoff warn of the danger of excessive public debt in
two papers, "This Time is Different: Eight Centuries of Financial
Folly" and "Decade of Debt." Essentially, both papers warn that
public debt in advanced economies has risen to levels not seen
since the end of World War II. They point out that high debt
leverage levels have historically been associated with slower
economic growth and higher rates of default or restructuring.
To avoid that fate, your investment portfolio should be filled with
companies that have strong balance sheets and positive free cash
flow to enable them to invest through the downturns.
Conservative balance sheets insulate companies from economic
slowdowns and reduce their financial risk, which in turn improves
your investment portfolio risk/reward profile.
I recently took a look at the energy sector to find companies with
strong balance sheets and positive cash flow after debt leverage
service costs, and most importantly, strong production growth
Companies I identified include
Suncor Energy (
), Chart Industries (
), National Oilwell Varco (
), Apache (
), Energy Partners (
Energy XXI (EXXI).
Leverage is and should always be a financing decision, not an
So how do you use this information to improve your investment?
First ask yourself whether the investment has more upside gain
potential than downside loss potential.
If it does, and you decide to make the investment, then decide
how to finance it. If you believe financing makes a bad investment
better, then you probably believe in a free lunch.
Last September, I visited
Suncor Energy (
in Calgary, Canada. The company is an integrated energy company
that develops petroleum resource basins in the Athabasca oil sands;
this involves the acquisition, exploration, development, production
and marketing of crude oil and natural gas in Canada and
internationally; transportation and refining of crude oil; and
marketing of petroleum and petrochemical products primarily in
The company has a credible growth plan of disciplined capital
investment to fund future projects for the next 20 years, investing
through the cycles but not at the expense of productivity and the
Suncor's focus is on steady 10% production growth per year from
2011 to 2020 for oil sands and 8% for the total company. To
maintain productivity, avoid downtime and cost overruns, it prefers
not to rush projects; management has a 25- to 30-year view on
production, unlike conventional E&Ps where the view is two to
Suncor's balance sheet is strong with debt to capital including
cash at 13%, capital spending is on target, generating high levels
of free cash flow after capital spending and dividends.
The stock is trading well below its 52-week high. According to my
discounted cash flow models, SU is currently trading at about a 25%
discount to market, so I value SU at 36, using a conservative 2012
price of $90 for West Texas Intermediate crude oil.
Good luck out there, keep your head down, eye on the ball,
shoulders square, in balance and follow through.
Your guide to energy investing,
Cabot Global Energy Investor