May 17, 2019

What are Safety Ranks and how can they be used?



"This stock has good safety." If we make such a statement at Obermatt, one could think that we consider it safe to invest in that share. But no, be careful here: it means something else. If we have a company with a good Safety Rank, then it means that the company is securely financed. So, what we are looking at is the way the company is financed. More precisely, companies that have a lot of debt are not financed as securely as companies with less debt. In other words, the Safety Rank is a "debt rank".

How important is that for you as investor? First, you need to know how the Safety Rank is calculated. To do this, we look at the financing structure of companies. First of all, companies are financed with equity. It is the money they get from their shareholders. If you’ve bought stocks yourself, the money you paid for them went into the equity of the company.

Debt is the second most important source for financing companies. Companies borrow money from banks or on public markets. These borrowings finance the facilities a company needs to produce the products and services for their customers.

Unfortunately, debt can lead to problems. If, for example, assets decrease (e.g. due to economic developments or company-specific problems such as low business), the debts remain the same. This reduces the equity capital. For you as a shareholder, this is a problem, but also an opportunity. Because if the opposite happens, i.e. the investments grow because the company is doing well, then the debts also remain constant. This, in turn, means that the equity capital grows and you as a shareholder profit.

The first Obermatt Safety Rank is therefore the ratio of debt to equity. The smaller the debt compared to equity, the smaller the debt ratio, and the better the debt rank. The debt-to-equity ratio which is referred to as leverage by professionals is thus the first Safety Rank that we calculate at Obermatt.

For the calculation of the second Safety Rank, we look at the fact that companies have to pay back their debts at one point in time. When this happens, these matured debts are reported in the balance sheet as "short-term debt". This can also become a problem. If these short-term debts turn out to be very large compared to the company as a whole, there is a risk that the company will no longer be able to refinance itself or that it will find it difficult to do so. For this reason, we calculate the Refinancing Rank. It provides information on how easy it is for a company to repay its debts with new long-term debt.

Last but not least, every company has to pay interest on its debts. But these interest payments can only be paid with profits. That's why we put interest in relation to the company's profits. That's what we call "liquidity".

At Obermatt, we have three key figures that measure the financing risk in relation to the size of the company:

  1. The Leverage Rank
  2. The Refinancing Rank
  3. The Liquidity Rank

These three ratios are included in the consolidated Obermatt Safety Rank. The higher it is, the less problematic the ratios between financing risk and company size.

How much can we rely on the Safety Rank? The answer is "a lot.'' The problems that could mislead safety ranks are relatively minor. This is for the simple reason that companies' accounting standards want to represent all debts as accurately as possible. The aspect of safety is the most important thing in accounting. Therefore, the information on the balance sheet is quite reliable.

However, there is a situation where our Obermatt Safety Ranks do not always provide the right picture. This is the case when a company decides not to sell its products but to offer them for leasing. As a result, no cash income is generated on these products; instead, money must be raised to make the products available to customers. This increases debt. At the same time, however, the credit balances against the customers increase, so that the problem hardly matters anymore.

At Obermatt, we try to isolate such situations and only compare companies with similar business models. But it is not always easy to exactly identify the leasing businesses. So it may happen that we don't recognize it, which means that the Safety Rank is lower than it should actually be. This is also the reason why I have bought shares with a low security rank - in these cases, I knew the reason and disregarded it because I wasn’t worried about it.

For me personally, the Safety Rank is the second most important rank at Obermatt. For the valuation of a share I start with the Value Rank because I don't want to buy shares that are too expensive - they should be as cheap as possible. But in the next step, my focus is on the Safety Rank, especially when the economy is not that stable. And finally, I look at the Growth Rank and the company itself. I judge its future. As you can see, safety is quite important when investing.



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