“The balance sheet is more difficult for management to manipulate and may offer the best opportunity to uncover financial improvement or decay.”

At Prospector, one of our main priorities when we are looking at a company is to assess our downside risk. We believe the best way to do this is by focusing on the balance sheet rather than the income statement.

Why?

Company management teams typically spend the bulk of their time polishing and massaging their company’s income statements because that’s what most investors care about. Executives are often preoccupied with: How should I set guidance? Will I be meeting or beating the market’s expectations?

So, we spend the least amount of time paying attention to income statements and focus instead on balance sheets and cash flow statements. These reports are more difficult for management to manipulate and often offer the best opportunities to uncover financial improvement or decay.

This is contrary to the approach taken by most investment firms. Part of the reason we believe we have an edge in looking at the balance sheet first is because of our team members’ unique skillsets. With many CFA and CPA designations, as well as strong backgrounds in both accounting and financial analysis, we pride ourselves on being excellent balance sheet detectives and spend a considerable amount of time focusing on the accounting side of things. This includes going beyond the GAAP financial statements and analyzing regulatory filings when available.

When diving into a company’s balance sheet, we analyze its integrity and value, both from an accounting and a market value perspective. In general, we like to see a high degree of conservatism in both the marking of assets and liabilities and in terms of where the company is valued in the marketplace. That tends to be our first focus.

Our second focus is on a company’s free cash flow generation — its consistency and predictability. This doesn’t preclude us from looking at a more cyclical business that’s generating strong free cash flow, but we tend to be more willing to pay a premium for a strong, steady track record of free cash flow generation. Those are some of the main tenets that we are looking at when we evaluate companies.

By focusing on companies that generate strong free cash flow, we construct portfolios with solid, less-leveraged balance sheets and limited need to regularly access the public equity markets to fund their operations. This is especially important during troubled times when smaller and medium sized companies lose access to the capital markets. 

In upcoming blogs, we will be illustrating these points with real-world examples of companies with balance sheets that, once we peeled back the layers, indicated better or worse investments than their other financials implied.

If you would like to be notified when we release new market insights, please let us know!  Just complete the form on this page and we will deliver our insights to your inbox once per week.