Time to Refocus on the Balance Sheet

 | Nov 08, 2012 | 12:30 PM EST
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Over the past couple of years, as stock prices have continued to climb higher, investors tend to pay more attention to the income statement. To be sure, earnings growth drives investment returns, but my concern is that investors are focusing too much on the income statement, and the balance sheet is acting as a sidekick. Given today's stretched equity valuations, investors should refocus more attention on the balance sheet.

A strong, healthy balance sheet is the defensive line of a business. And as my favorite football coach, Nick Saban of Alabama (I'm a Georgia Bulldogs fan at the core, but I think Saban is a gridiron genius), demonstrates time and time again, most recently last week against LSU, defense can often be the best form of offensive. A strong defense will protect you during the times when your offense is not at its best.

In business, this philosophy of a strong defense is critical. A strong defensive company, one with a strong balance sheet, creates a valuable degree of downside protection when the company's offensive position -- revenue and profit growth -- stumbles. Most importantly, a strong balance sheet lets the company dictate its future outcome. And when a business is faced with economic uncertainty, that control can mean the difference between future prosperity or a future of mediocrity.

Investors are going to be faced with a degree of market and economic uncertainty in the near future. As I opined in my column yesterday, that uncertainty should not be an absolute deterrent to making investments if the price value equation is right. Even after yesterday's market drop, there are not a lot of attractive opportunities today. But some names are still hated by Mr. Market, and that disdain can often create an attractive price.

Small-cap Sterling Construction Apple (STRL) is such a name. After climbing as high $17 a little over a year ago, shares have settled around $9-$10. A few unprofitable projects and continued uncertainty relating to federal highway spending have kept investors on the sidelines. The company is debt free and holds $4.20 a share in cash, and book value per share is nearly $13. Sterling will report after the market closes today. If the news is just minimally favorable, I suspect the undervalued stock price will react positively. If the quarterly is not favorable, a further decline will make the share price more intriguing in the context of the pristine balance sheet.

Financials were hit hard yesterday in response to the election, on the assumption that tougher regulation is in the future for the financial industry. My only response to that is to look at the stock market performance of the big financials so far in 2012: Goldman Sachs (GS) up 24%, Wells Fargo (WFC) up 16% and Bank of America (BAC) up more than 70%. If the shares continue to slide, remember that you are investing on the basis of how attractive the price is relative to all other obstacles. Financial regulation has always existed.

Avoiding loss of capital -- being defensive -- can often be the best offensive strategy. An investor's opportunity set includes not only the opportunities of today but those of tomorrow.

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