Someone emailed me this question:
“…how do you consider negative shareholder equity? Is this good, bad or other?”
Before I give my answer, I apologize to the roughly 60% of my audience that I know is made up of non-Americans. I’m about to use a baseball analogy.
Like Warren Buffett has said: the best businesses in the world can be run with no equity now.
I've invested in companies with negative equity. Most notably, IMS Health in 2009.
I would always notice negative shareholder equity. It would make me more likely to want to learn about the stock - because it's odd.
Remember, you are looking for extraordinary investment opportunities.
We can break that search into two parts: “extra”+”ordinary”.
Sometimes, we know whether something is a "plus" or a "minus". Other times, we only know it's an anomaly without knowing whether it's "good odd" or "bad odd".
As an investor, you always want to investigate anomalies. However, you don't always want to invest in anomalies. There's a difference.
Say we're searching for a good or even a "great" stock. The first thing we know for sure about this hypothetical good or great stock we haven’t yet found is that it's not ordinary.
Negative shareholder equity is very not ordinary.
In the past, I've compared negative shareholder equity to the number of strikeouts a Major League batter has.
We know high strikeout rates are good for a pitcher.
However, there is considerable debate about whether high strikeout rates are good or bad for a batter.
Theoretically, it's better to have positive equity than negative equity. For example: if IMS Health looked exactly like it did when I found it plus it had billions in extra cash on the balance sheet - that'd be better.
But, that’s like saying it’s better to have a stock with a 17% growth rate and a P/E of 7 rather than just a P/E of 7. In the real world: a P/E of 7 is plenty interesting all on its own.
And, using our baseball analogy: Theoretically, it's always better to have not struck out rather than struck out (excluding the possibility of double-plays).
Yes, if Babe Ruth had the same number of home runs plus some of his strike outs were instead balls he put into play - he'd be an even better batter. But, let’s face it: if your job was picking the right guy to have on your team – identifying the next Babe Ruth is all you need to do.
So, let's forget theory for a second. Let's look at the cold, hard facts.
What does the data say?
The data actually says that some of the best batters in Major League history had unusually high strike out rates.
And the data says that some of the best stocks around have unusually low shareholder's equity.
So, if I'm a general manager who sees a batter with an absurd number of strike outs, I know I want to learn more. I don't know I want to trade for this player. But, I know my eye is drawn to this statistical anomaly.
And, if I'm a value investor who sees a stock with an absurdly low amount of shareholder equity, I know I want to learn more. I don't know I want to buy the stock though.
Because a batter with a high strikeout rate could just be an absurdly bad batter. It's unlikely he'd get this far if he was - but it's possible.
And a public company with a low amount of shareholder equity could just be a distressed company.
So, when you see a stock with negative shareholder equity, imagine it's shouting "Research me! Research me!". Don't imagine it's shouting "Buy me! Buy me!"
I can't say negative shareholder equity is always good or always bad. I can say it's always worth investigating.