Watch the Debt When Markets Are Fair

May 25, 2011 by Joe Ponzio

A little over a year ago, I had discussed Jackson Hewitt Tax Services (JTX) and how an investor should ignore the price and focus solely on the business. In doing so, you can often (though not always) see problems arising at your companies before those problems appear in the stock price.

The second largest paid tax-preparer in the country, Jackson Hewitt thrived in an industry that was all but certain:

There are only two certainties in life – death and taxes.

I’ve heard the argument a million times:

Yeah, but it’s [insert company name here]. They own the world. They’re not going anywhere!

The same was said over and over again on the Yahoo! Forums about Jackson Hewitt. There was endless blathering about agreements with Walmart, Republic Bank, IRS regulations, the need to file taxes. On and on it went as speculators (we can’t call them “investors”) rationalized why they were buying or holding Jackson Hewitt…from $33.00 all the way to $0.70.

(The Yahoo! Forums are chok full of nonsense, but they’re an interesting place to go if you want to see what goes through speculators’ heads.)

Too often, people jump into stocks without a thesis and with little more than hope. And while we all agree that these are businesses, those same people will ignore the business entirely or give it little more than afterthought consideration, routinely get clobbered, and then insist that the stock market is nothing more than a crap shoot.

Guaranteed Customers + Guaranteed Industry + Guaranteed Pricing (More or Less) + Unmanageable Debt = Bankruptcy

It’s a simple formula, but one that is regularly ignored by many. A stock (or company or government, if we want to go there) is more than its daily operations or the utility or look of its products. We have to look at its obligations because, if those can’t be met, little else matters and an “investment” is nothing more than a gamble.

And you can’t rely on Wall Street to give you the heads up on things.

March 31, 2011: An investment banking firm says that odds are increasing that Jackson Hewitt will enter bankruptcy after the end of this year’s tax season.

By focusing on the business, you don’t have to wait for the stock to trade at $0.50 to make these determinations.

Benjamin Graham focused almost exclusively on balance sheets for much of his career. Though in his later years he began to appreciate cash flows and income statements (hat tip to Warren Buffett, the student teaching the teacher), Graham built his fortune and fame by analyzing debts, debt structures, and adjusted asset valuations.

Why the Focus on Balance Sheets Now?

The markets are more fairly valued today than they have been at any time in the past three years (or so). From fairly valued, the markets have one of three ways to go: up, down, or nowhere. By focusing on the balance sheets more, investors have historically been able to: (1) enjoy immense growth if markets rise, (2) protect themselves and be ready for recovery if markets fall, and (3) profit when Mr. Market realizes that the company — perhaps beat down because of industry weakness or a terrible quarter — has sufficient assets to survive the storm.

When the markets are flying high and money is freely available (as we’ve seen in years past), debt is considered a non-issue by many. After all, it can always be refinanced or kicked down the road, right?

Then again, I prefer to think of it this way (Warren Buffett via Monish Pabrai):

When you have debt, you have to wake up every morning and worry about what the world thinks of you.

That’s even more true today when lenders are slow to refinance and quick to call less-than-desirable debts. That’s what happened to Jackson Hewitt — they were able to kick the can down the road and refinance tomorrow’s obligations and losses today…for a while, at least. But eventually, reality caught up with them, as it does with every company at some point.

Are the Markets Fairly Valued Today?

We’re getting there. No single indicator will tell you exactly where the markets should be, but when the main ones start throwing up similar signals, it’s worth consideration. So…consider this:

  • the earnings yield of the S&P 500 is around 5%-6% or so, a pretty normal value historically under normal conditions.
  • Graham-style net-nets are virtually impossible to find (though they’re around every corner when stocks, in general, are cheap).
  • the market value of US securities is roughly the same as the current Gross National Product (GNP).

It’s not enough to move it all to cash, buy bonds, and wait for the pullback; still, investors should remain cautious and allow for even less wiggle-room in the balance sheet than might otherwise be allowed under “cheaper” market conditions.

What are your thoughts? Are the markets fairly valued or are you on a buying spree right now?

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