55: Why Equity Investors Should Know The Five C's Of Credit?
Rule #1: Don't lose money; Rule #2: Don't forget rule #1
You’re reading the weekly free version of Watchlist Investing. If you’re not already subscribed, click here to join 1,100 others.
Want more in-depth and focused analysis on good businesses? Check out some sample issues of Watchlist Investing Deep Dives.
For less than $17/month, you can join corporate executives, professional money managers, and students of value investing receiving 10-12 issues per year. In addition, you’ll gain access to the growing archives.
Keep that credit hat on!
I know for a fact my decade spent in commercial banking helped make me a better equity investor. I firmly believe every equity investor should gain some of this experience, if not directly then indirectly. Where to start? A good launching point are the five C’s of credit, something every good banker knows to their core. They are: character, capacity, conditions, capital, and collateral.
Character:
This is perhaps the most important overarching consideration. J.P. Morgan (the man) famously stated:
“The first thing [in credit] is character … before money or anything else. Money cannot buy it.… A man I do not trust could not get money from me on all the bonds in Christendom. I think that is the fundamental basis of business.”
Warren Buffett put it another way:
“You can’t make a good deal with a bad person.”
Buffett famously drives his lawyers crazy with how little apparent due diligence he does before signing deals. Buffett knows character comes first and that’s what he focuses on when considering a deal (after the economics check out of course). Contracts are simply there to memorialize what both parties already agreed upon.
As a commercial lender, I once lent money to a dry cleaner run by a 1st generation immigrant. The books didn’t look great and so we were obligated to button things up with an SBA guarantee in addition to the standard personal guarantees. But from my perspective, I would have lent this woman my mother’s retirement savings on an unsecured basis. She was at her shop from dawn to dusk six days a week, had prices below her competition, an excellent location in a busy shopping center, and put out fantastic work. I have no doubt she’d quite literally sell the clothes off her back to repay the bank. That’s character.
Capacity:
Otherwise known as cash flow. All the character in the world won’t repay a debt without some sort of cash flow. It’s important to understand all the nuances of cash flow, positive and negative. Business profits might not translate into free cash flow because of receivables growth, for example. And on the other side of the ledger outflows should be considered for their timing. It’s liquidity that usually does companies in not insolvency.
Capital:
Speaking of insolvency, capital is of great importance. Is the balance sheet leveraged, or is there room for additional borrowing? Are there off-balance sheet liabilities that need to be considered in addition to explicit debt or lease obligations? How much personal skin in the game does management have at stake?
Conditions:
The general context in which a business operates is also important. Is the overall economy in a recession or are times good? How sensitive is the industry to general economic conditions? Is there a history of industry-specific slumps, independent of general business conditions? Is the operating environment cyclical? Where is the business environment in that cycle? Are there long-term structural trends that should be considered?
Collateral:
This last C is primarily for creditors. Personally, I stay away from companies with big debt loads or that are overly reliant on debt financing. But as an equity investor you should understand if any business assets have been pledged to secure a loan. Are there any covenants you should be aware of? What are the remedies if the company breaches a covenant?
All investors would do well to think like a banker or debt investor. Even if the company under consideration has no debt whatsoever, putting on your credit hat is a useful tool to screen for risks other investors might miss. As Warren Buffett has said on numerous occasions, take care of the downside and the upside will take care of itself.
If you enjoyed this post I’d appreciate you taking a moment to help me spread the word by sharing it. Thank you!
Stay rational! —Adam