Classic value investors avoid financial firms such as Fairpoint Group (LSE: FRP) for the very plain and simple reason of an exceptionally weak balance sheet.
Quite apart from Fairpoint being listed on AIM here at Shares and Stock Market financial firms have a special risk category that makes them a no-go area due to the historical instances of cavalier boards of financial firms who mismanage leverage, other people’s money and ultimately shareholder value.
Just look at the balance sheet of Fairpoint: it’s intangible assets – a topic I’ve covered before here on the blog regarding acquisitions made by companies – is a whopping 40% of total assets reducing book value accordingly.
The 2015 accounts had an impairment of goodwill to the tune of £9,010,000 ‘being recognised in these Company financial statements against its investment in Clear Start UK Limited’.
Blah, blah, blah hindsight is a wonderful thing and all that jazz but balance sheets are the hardest of the financial statements to manipulate which is why classic value investors place much more emphasis on their numbers than that of the others.
If you look at liabilities you will see how they exploded from £24 million to £46 million from 2014 to 2015 and as for assets £10.6 million is listed as ‘unbilled income’ – well if income is unbilled how can it be an asset? How can investors be sure that any income due to the business is legitimate if it has not been properly ‘booked’?
Judge for yourself because here are what the notes say:
Unbilled income in relation to work performed in the legal services segment is recognised based on the status of the case, the likelihood of recovery and the expected recovery rate. Where a case is contingent at the balance sheet date, no revenue is recognised. Where entitlement to income is certain, it is recognised at selling price or estimated selling price based on an analysis of historic recovery rates. Where the entitlement has not yet been quantified, it is valued at cost. Appropriate provisions are made in respect of unbilled income based on the age of the related time cost.
Shares and Stock Markets translation service: we’re guessing that the money we think we are entitled to we will probably get at some point in the future i.e. it’s not in the bank yet, but I promise it will be.
Disclaimer: there is no magic value investing wand.
Nothing is ever certain in financial markets.
The only thing that is certain is management of risk i.e. assess the risks, act accordingly.
The balance sheet is there to help you assess how much real assets you have as a shareholder against any of the threats that will sour your investment including a manipulative board.