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How to Protect Your Portfolio from Losses

15 September 2014 marked the sixth anniversary of Lehman Brothers going bankrupt. The American investment bank’s collapse was one of the landmark events during the Global Financial Crisis of 2007-09.

When the bank went under, it was subsequently revealed that it owed its creditors some US$341 billion. On the sixth anniversary of its bankruptcy, Marie Beaudette from the Wall Street Journal revealed that the bank’s creditors can now “expect to recover about [US]$88.8 billion.” That works out to be a recovery value of roughly 25 cents on the dollar.

This for me is a stark reminder for investors to always keep an eye out on a company’s financial health.

When a company goes bankrupt, shareholders are the last in line to claim any assets, with creditors having first claim. But when there are cases where creditors as a group can only lay claim on 25 cents for each dollar owed (as it is for Lehman), it’s as good a warning as any that companies in precarious situations with regard to their financial health can result in a total loss for shareholders.

I’ve recently shared two things investors can do to help reduce the chances of them making mistakes when investing. The first is to avoid companies with businesses that have poor economic characteristics; the second is to avoid shares with rich valuations which cannot be supported by their underlying business fundamentals.

I’d like to add on a third thing you can do: Avoid companies with balance sheets which carry heavy debt loads.

Of course, there are good examples of companies with heavily-leveraged balance sheets which go on to become great investments. Telecommunications operator Starhub Ltd. (SGX: CC3) is one such instance. It has been heavily leveraged ever since it was listed in October 2004 (as seen below), but its shares have generated total returns (where gains from reinvested dividends are included) of 759% since the close of its first day of trading.

Year Net cash (S$, millions)*
2005 -64
2006 -578
2007 -825
2008 -793
2009 -666
2010 -572
2011 -486
2012 -380
2013 -421

*Net cash = Total cash minus total borrowings

Source: S&P Capital IQ

But that said, it would still be companies with clean balance sheets which present the least financial risks for investors. As the great investor Walter Schloss once said:

“I like to look at the balance sheet and I don’t like debt because it can really get a company into trouble.”

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.