Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 191

When a company is a money pit

“Assets collect risks around them in one form or another. Inventory is one risk, and accounts receivable is another risk.” – Michael Dell, founder and CEO of Dell Technologies.

All businesses face the ongoing challenge of generating cash flows in excess of their borrowings. If a business is unable to pay its debts owed, it is no longer a ‘going concern’ and will face reorganisation or liquidation. Nevertheless, profitability is not necessarily a prerequisite for a business’s ongoing survival. A business can keep losing money if investors keep pumping cash back in, often in the vain pursuit of growth opportunities that, for some reason, cannot be funded through existing profitable operations.

Watch for the death spiral

Some businesses may even have the duty to continue unprofitable operations if they need to keep servicing their debt, to the detriment of equity holders. This is the unhappy scenario where excess debt begets excess production and forced sales through reduced prices. Lower prices require higher production volumes to meet the same existing debt burden, and the death spiral continues.

Forced asset selling or ‘deleveraging’ is a variation on the same theme, as is the current predicament of cash-strapped energy producers. While the law of supply and demand suggests that they limit supply to drive up prices, the need for immediate cash flows defies this and ultimately lowers the return on their assets, perhaps changing the nature of the assets in the process.

“We started the company by building to the customer’s order. And, interestingly enough, we didn’t do it because we saw some massive paradigm in the future. Basically, we just didn’t have any capital to mass-produce.” – Michael Dell

Different types of capital and liquidity

Asset values and their power to generate profits are joined at the hip. Some would say that net profits provide the best way to value the assets of a business, since assets are only worth the cash flows they can generate. This is a useful concept, but it overlooks the overall convertibility of the assets, or how they fare in a liquidation scenario. The more capital intensive a business is, the less valuable its capital actually is, all things equal. If invested assets strain to generate profits as a going concern, they will likely strain to achieve satisfactory prices in liquidation. Similarly, the very fact that assets may be relatively liquid would likely prevent their ‘forced liquidation’ in the first place and accordingly, this should be considered when performing valuation analysis.

This points to a duality between the profitability and liquidity of assets as they pertain to the risks of the equity holder. Both imply an ease of converting assets into cash and, in this sense, may act as substitutes for each other in the reduction of equity risk. Equity investors, as a rule, forego the safety of cash to make their investments. To the extent they can get it back, they might have their cake and eat it too.

Recognising this duality can uncover more investment opportunities with a greater skew to positive outcomes. The good ones may be less exciting or glamourous unless you happen to like specialty chemicals or Pachinko balls. They often combine a modest upside with a very limited downside and can be fantastic investment opportunities since, while the equity risk is reduced, the participation in business or economic value-add is preserved.

Some investors bemoan ‘lazy balance sheets’ with excess cash and lower return on assets on paper, but they shouldn’t overlook the downside protection that this liquidity inherently provides. ‘Optimising’ balance sheets by leveraging up to juice equity returns comes with its own risks. Only to the extent that operational and business risks can be eliminated can leverage be safely applied, and history is littered with investors who have gotten this balance wrong, with nothing left to show for it.

"When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbors get envious," explained Warren Buffett in his 2010 Shareholder Letter. "But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people."

Equity investors assume fundamental risks (e.g. the level of borrowings) and should be aware of the relative severity in their investments. If and when prevailing market prices permit them to capture most of the upside they expect from their equity investments, while severely limiting their downside, investing first principles should be the guide. Almost by definition, these opportunities are unlikely to be headline-grabbing growth stories that lead to exciting narratives and visions of the future.

 

Peter Bull is Head of Equities and Nimalan Govender is a Portfolio Manager at Morningstar Investment Management Australia. This article is general information and does not consider the circumstances of any individual.

 

banner

Most viewed in recent weeks

Retirement is a risky business for most people

While encouraging people to draw down on their accumulated wealth in retirement might be good public policy, several million retirees disagree because they are purposefully conserving that capital. It’s time for a different approach.

The perfect portfolio for the next decade

This examines the performance of key asset classes and sub-sectors in 2024 and over longer timeframes, and the lessons that can be drawn for constructing an investment portfolio for the next decade.

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

The challenges with building a dividend portfolio

Getting regular, growing income from stocks is tougher with the dividend yield on the ASX nearing 25-year lows. Here are some conventional and not-so-conventional ideas for investors wanting to build a dividend portfolio.

How much do you need to retire?

Australians are used to hearing dire warnings that they don't have enough saved for a comfortable retirement. Yet most people need to save a lot less than you might think — as long as they meet an important condition.

Welcome to Firstlinks Edition 594 with weekend update

It’s well documented that many retirees draw down the minimum amount required and die with much of their super balances untouched. This explores the reasons why and some potential solutions to address the issue.

  • 16 January 2025

Latest Updates

Investment strategies

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

9 ways to fix Australia's housing crisis

Decades of policy failure have induced a fall in housing affordability. Unless painful changes are made, an underclass will emerge in a society that is supposed to boast the one of the world's highest standards of living.

Shares

Australia: why the chase for even higher dividend yields?

Australia boasts one of the world's highest dividend yielding sharemarkets, providing substantial benefits to investors and retirees. Despite this, individuals often stretch for even more yield, to their detriment.

Shares

MIGA – Make Income Great Again

The Australian sharemarket seems to be rewarding a number of unprofitable companies on the promise of future riches. Yet profits and cashflows still matter, as a recent case study of Domino's Pizza shows.

Shares

Mapping future US market returns

Exceptional returns from the US sharemarket over the past decade have driven by sales growth, margin expansion, rising valuations, and dividends. Predicting future returns requires careful consideration of these factors.

Shares

Read this before you go all in on US equities

US equities rule global markets, but history is littered with examples of markets that seemed invincible — until they weren’t. Diversification will be key for investor portfolios going forwards.

Property

What impact would scrapping stamp duty have on housing?

Increasing house prices pose challenges for housing affordability. This investigates the impact of stamp duty on the property market, and how removing the tax could help address several key issues.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.