From Dan Ferris in Extreme Value:
The most difficult question in all of investing is the problem of knowing what to do with a stock you own has fallen below the price you paid for it. Do you sell and take the loss, hold, or buy more?
Part of the answer, I've decided, is investing in companies with an ongoing excellent financial condition.
Another way to answer this question is to determine what, if anything would be left over if the company were to pay all its liabilities. With many companies, there wouldn't be much left over, even though shareholders' equity might be a large number. That's why I prefer companies with plenty of liquid assets on the balance sheet. It's easier to value cash and securities than, say, a copper mine or a manufacturing plant.
Not only does a pristine, liquid balance sheet tend to make valuation easier. It makes it more certain a company will be able to pay its creditors. Let's never forget the list of claims senior to the common stockholder, which we first published in the September 2007 issue of Extreme Value:
1) Secured creditors get paid when the pledged property is sold or refinanced, then
2) Unpaid wages, then
3) Taxes, then
4) Trade creditors, then
5) Unsecured debtholders, then
6) Subordinated unsecured debtholders, then
7) Preferred stockholders, and finally, after all these other claims are met,
8) Common stockholders get whatever is left.
The common stockholder is the last one to get paid. So he'd better be certain the company can pay all claims senior to his with room to spare.
When you're highly certain the company has plenty of assets and/or earnings left over to pay the common stockholder, it's much easier to hold or buy more of a stock that has fallen below what you paid for it. You're sure the company can meet all its liabilities, so there's no worry its business will get into serious trouble, no matter what Mr. Market may think of the stock in the short run.
Dan Ferris is the editor of Extreme Value. For serious investors, it's one of the most useful advisories you can buy at any price. Dan has a gift for finding "World Dominators" - the highest quality stocks with tons of upside. If you're not already a subscriber, you owe it to yourself to click here
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