As the saying goes — tough times don’t last, but tough people do. The same applies for businesses.
It sure feels like investors are in the midst of tough times right now, with the Covid-19 virus outbreak upending supply chains and disrupting various industries.
Though it’s only been two months since the outbreak began, several industries are already facing significant challenges. Many companies are seeing sharply reduced demand for their products and services, while supply-side problems have yet to be fully resolved as factories remain shuttered.
It now seems certain that many companies will be reporting significantly lower profits for this quarter, or even losses.
But all is not lost for investors like you and me.
During times like these, companies with strong balance sheets can stand a better chance of weathering the storm and emerging unscathed.
The definition of a strong balance sheet
So, what constitutes a strong balance sheet? There are two key aspects to this.
One is that a business should have high-quality physical assets such as properties. These assets will be able to hold their value amidst the turmoil and allow the company some measure of stability.
An example would be Hongkong Land Holdings Limited (SGX: H78) which owns properties in prime locations in both Singapore and Hong Kong. The value of these properties is likely to hold up even during a crisis, and investors can have a good night’s sleep knowing that these are quality assets situated in prime locations.
The second aspect would be companies with large cash balances with minimal or no debt. During a crisis, the cash would come in handy as a buffer that the company can tap on to continue operations.
Having low or no debt also means the business is not beholden to banks, as finance costs may suck away valuable cash flow that can be used as working capital.
Hunkering down during storms
An example of a company that is hit badly by the Covid-19 outbreak is Straco Corporation Limited (SGX: S85). The group owns three key assets — two aquariums in China and 90% of the Singapore Flyer.
However, due to the stringent quarantine procedures laid out by the Chinese Government in late-January, both of Straco’s aquariums have had to temporarily shut.
In Singapore, the Flyer is also down due to a technical fault reported in November 2019. So, the group is essentially left without any revenue generation sources.
Luckily, the group had plenty of cash on its balance sheet prior to this crisis. That allows them to be able to hunker down and weather the storm better than competitors who may be heavily indebted, such as Haichang Ocean Park Holdings Ltd (SEHK: 2255).
As of 31 December 2019, Straco held S$199.45 million in cash with gross debt of around S$25.9 million. Net cash stood at S$173.55 million. Haichang, on the other hand, was saddled with RMB 8.2 billion worth of debt as of 30 June 2019, with only RMB 2 billion in cash.
Reducing the risk of shocks
The idea behind buying companies with strong balance sheets is to reduce the risks of shocks or nasty surprises.
While almost all businesses will suffer during a protracted economic crisis, the storm will eventually pass and only the strong ones will survive.
Businesses with weak or frail balance sheets are at higher risk of failure as they may have debts to repay, or may have insufficient cash buffers to continue their operations.
Get Smart: Strength equates with resilience
As an investor, we would naturally feel worried and anxious when a crisis hits.
We have spent time and effort to invest our money in promising companies, but it seems like our forecasts and projections have now gone out the window.
But all is not lost.
While businesses may suffer during a downturn, the best of the bunch tend to come out of the crisis stronger than ever. Perhaps, with less competitors.
Investing involves sizing up probabilities and deploying capital efficiently based on this assessment.
Companies with strong balance sheets have a much lower probability of running into trouble during crises.
Strength, in this case, equates with resilience. Resilient companies can weather storms better and will eventually emerge even stronger thereafter.
These are the kinds of companies that give investors peace of mind.
Disclaimer: Royston Yang owns shares in Straco Corporation Limited.