Balance sheet strength

Some of the most spectacular gains I have racked up on my stock picks have been made by screening for companies valued on large discounts to net asset value and where the intrinsic value in the company's assets is not being accurately reflected in the share price. As a secondary screen I try to avoid highly geared companies for the simple fact that I am happy to take on operational risk, but really don't want to expose myself to the financial risk of a company being unable to service its debts at the same time. In fact, I like companies with net funds so there is minimal financial risk. But even if I do recommend a company with significant borrowings, I always assess the cash generation of the business to decide whether underlying cash flows are strong and sustainable enough to comfortably service debt. As a result, I very rarely recommend shares in any company where net debt is above 80 per cent of shareholders' funds.

This means that any improvement in the trading performance can act as a very strong catalyst for a rerating to narrow the share price discount to book value without investors fretting about levels of balance sheet gearing.

A classic example of this was Walker Greenbank (WGB), the luxury interior furnishings outfit, whose brands include Morrison & Co and Zoffany, which was being valued on a 30 per cent discount to net asset value when I first spotted the investment opportunity ('Luxury at a bargain price', 8 Feb 2010). The company only had gearing of 17 per cent but, importantly, the business appeared to be in the very early stages of recovery and an earnings upgrade cycle. It was the real deal and by the time I advised banking profits 18 months later ('Time to bank some gains', 23 Aug 2011), we had made a 118 per cent profit on the holding as other investors had also cottoned on to the fact that Walker Greenbank's strong cash-flow-generation was not only rapidly reducing the company's borrowings, but paving the way for sharp increases in the dividend, too.