Is Float Ever Bad? On Float Part 6
The goal of this blog is to help us all improve as investors and thinkers so we’re a little wiser every day. The hope being that our knowledge will compound over time so we’ll have huge advantages over other investors in the future.
The aim of today’s post is to continue this process by talking about a topic few investors know about. And even fewer understand.
Most people overlook float when evaluating companies because they either don’t know what it is. Don’t know the power it can have within a business. Or don’t know how to evaluate it.
This won’t be an issue here.
Press On Research subscribers already know this as I talk a lot about float in many of the issues I’ve written. But I want to begin talking about it more here because float is one of the most powerful and least understood concepts of business analysis.
Today’s post is a continuation of the earlier posts:
- Charlie Munger On Deferred Tax liabilities and Intrinsic Value – On Float Part 1.
- What is Float? On Float Part 2.
- Buffett’s Alpha Notes – The Power of Float – On Float Part 3.
- How To Find Float On The Balance Sheet – On Float Part 4
- How Does Float Affect Valuation? On Float Part 5
Today we’re going to answer the question “Is Float Ever Bad?
Is Float Ever Bad?
I’m a guy who likes to live by the above quote. If I can make things simpler I always do. Not only does this make things easier to understand but it also can save a ton of time.
When analyzing investments and dealing with complex topics like investment float this isn’t always possible.
Understanding the good things about investment float is definitely one of those things you can make only so simple. The concept is simple to understand but the there are a ton of different nuances to understand which leads to complexity. You can likely tell since it’s taken me 51 pages thus far in the five earlier posts to explain the good things about investment float.
Luckily the answer to the titled question is a simple one. And also involves simple and easy to understand concepts as well.
Yes, certain investment float is bad. And no, not all float is equal.
The heuristic or mental model I use when evaluating float is that if the company isn’t profitable – or near profitability – its float is useless. And can even be a negative burden for a company.
Remember, float are liabilities that can become positive leverage if used well by management and the company is profitable. But always remember leverage can go both ways as well.
If a company isn’t profitable and hasn’t produced profits in several years float turns into negative leverage. This is because in the long run float are liabilities the company will have to pay at some point.
The longer a company goes without earning profits the longer it will take a company to pay its liabilities because it’s not earning enough money. This also makes it harder to fund operations and grow in a healthy way without taking on a ton of debt or even more liabilities.
Let’s go through a quick example to show this.
Let’s say we have two insurance companies. Company A has an average combined ratio of 90% over the last five years and Company B has an average combined ratio of 110% over the last five years.
Not only does this mean Company A’s profits are 20 percentage points better on average than Company B. But it also likely means that Company B has continued racking up liabilities it can’t afford to pay when due or when a catastrophe strikes.
This is because Company B hasn’t earned a profit on average over the last five years. And of course all else remaining equal a company earning 20 percentage points better profit’s on average is the higher quality company.
The same general rule goes for non insurance companies as well. If they aren’t, haven’t been, and show no signs of becoming profitable float should be viewed as negative leverage for a company.
I use the following rules when evaluating all companies float…
- To view float as a giant positive for any company I like to see consistent profitability in the last five years. And/or seven of the last 10 years.
- If a company has off and on profitability I view float as neutral.
- And if the company is consistently unprofitable I view float as a huge negative for the company.
I consider profitability of operating margin, ROIC, ROCE, and FCF/Sales. The company doesn’t have to produce huge excess profitability in each category. I look for consistency and trend of profits more than anything when evaluating float.
This idea is a lot simpler to understand than the concept of what float is and makes it potentially great for companies and investors.
One last thing to remember when evaluating float is that whether the company has positive or negative acting float doesn’t matter if the company doesn’t allocate capital well. And the management doesn’t know what float is or how to use it.
To evaluate these potentials see the previous five posts on this topic.
If I’ve explained everything well enough in the series so far we should understand –
- What float is.
- Why it’s important.
- How companies can use float as positive leverage.
- How Buffett got so rich using float.
- How to find float on a balance sheet.
- How to evaluate float.
- How float affects a company and its margins.
- Maybe the most important thing why float affects a company and its margins.
- How float affects a company’s value.
- And answered the question is float ever bad?
In the next and final seventh chapter of this series I’ll share the best resources I’ve learned from about float with you.
Knowing what we know now we should have a gigantic advantage over other investors who either don’t know about float. Or aren’t willing to put in the time to learn what it is and what it can do for a company and investment.
If you have any questions, concerns, or comments on float up to this point please let me know in the comments section below.
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