Financial Strength Before An Economic Downturn

Do you know what was the most prosperous food company during the Great Depression? White Castle.

And not for the reasons you’d think. The well-known fast food chain that sells hamburger sliders was one of the most incredibly conservative enterprises I have ever studied. In 1929, it was loaded with $32 million in cash. None of the restaurants have ever been franchised. It had an explicit policy of only opening a new restaurant location when it could do so from its cash on hand, and rarely rented any machines. Everything was paid for in cash.

The financial strength of White Castle during times of calamity explain why the business is still around almost a century later.

During ordinary and good times, everyone talks about the benefits of leveraging to accelerate growth. It is now common practice in business schools to teach that the lowest amount of capital contributed to a firm is the secret to outsized returns–i.e. “using other people’s money.”

The problem with leverage is that profits can decline during the bottom of a particular business cycle, forcing dilution, borrowing at a high rate of interest, or even insolvency.

I always take into account the balance sheet of firms when I study them (it doesn’t mean that I won’t invest in highly leveraged firms, but rather, high leverage would need to be offset by a factor such as gibraltar-strength level earnings quality).

I look at a business like Shake Shack, and it appears to be following in the mold of White Castle in generations past. It has $92 million in cash, no debt, and earns $31 million per year in profits. The company is being managed in a way that it way be around for a long, long time. Remember, you cannot go bankrupt if you don’t owe anybody anything.

On the other hand, you have a busy like Wendy’s which only earns $100 million in profit and carries a debt load of $2.8 billion with $200 million in cash. Subtracting out the cash, its profits are leveraged 26-to-1. That leverage rate is so high I could never consider it as an investment.

The stock traded at over $14 in 1993. It trades at over $17 today. Why has no real wealth been created in twenty-five years of selling hamburgers and fries at Wendy’s? The answer is because profits collapsed during the 2008-2009 financial crisis and the business had to issue 250 million shares. It only had 93 million shares entering the crisis.

I am not impressed that Wendy’s has bought back a ton of stock over the past decade, reducing the share count from 467 million shares in 2008 to 235 million today. The share ownership of the business is still more than twice as diluted compared to what would be the case if Wendy’s was just conservatively financed and did not need to issue shares during the market lows of 2008. The effect is so drastic that shareholder wealth has not increased in a quarter-century despite over a billion dollars in profits generated.

This is part of the reason why I have personally woken up to the tech companies with $100+ billion in cash. It is delightful to own parts of businesses that are drowning in cash. With interest rates primed to rise, and the economy having advanced for nearly a decade, I strongly encourage investors to consider balance sheets to be a factor of significance in their investment analysis.