The Globe and Mail, Report on Business
Published January 10, 2009

When trying to explain what's going on in the stock market, we often draw comparisons to the housing market. It helps to put the mysteries of Wall Street into terms that people are more familiar with, namely real estate.

For the purposes of this column, the analogy is useful in discussing how a new economic order is developing in the corporate world.

For purposes of the comparison, the house is equivalent to the company's operating assets - its facilities, staff, products, customers and brand. In the case of the house and business, the assets have a capital structure laid over top. The homeowner likely has a mortgage on the house. A business may have some long-term liabilities against its assets, such as bank debt, bonds and/or preferred shares.

If the value of the assets drop from $500,000 to $400,000, not everyone is affected equally. Mature homeowners with no debt are down 20 per cent. That's serious money, but not nearly as bad as a younger family with a $300,000 mortgage. Their equity has declined 50 per cent.

Leverage and a 20-per-cent drop in asset value makes for a wide range of outcomes, which shape future options and actions. A family with a small mortgage and a need for more space can use the weak environment to upsize. They're smiling all the way. At the other end of the spectrum, the new owner who put zero down has been wiped out and is looking for rental accommodation.

In business, the severity and duration of the credit crisis has made a company's capital structure a key differentiator. The economic order is changing based on whether you're "levered" or "liquid." Companies with a clean balance sheet, no near-term debt maturities and some cash around haven't had to do anything new or different to move up the industry ladder. They've just held their place while their once formidable but debt-laden competitors have slipped into survival mode.

Think of it as revenge of the guy who drives a seven-year-old Honda Accord and has no mortgage, or the executive that finished second on his last three deals. Over the past five years, a period when anything that moved could get a loan, these under-levered "losers" lagged behind, but they're looking pretty good now.

The impact of the credit crisis has been nothing short of remarkable. One of the most extreme and tragic examples of this is Teck Cominco. The company is well run, owns high-quality assets and is diversified across different commodities. And it has always had a strong balance sheet, until recently when it did a heavily leveraged deal at the top of the market (Fording Coal). With the rapid decline of commodity prices, Teck has gone from being one of the world's leading mining companies to fighting for its life, all in a matter of months.

Teck, and other firms like it (levered), will be forced to sell assets at distressed prices and/or dilute existing shareholders, just as the banks have done. And they need the credit markets to open again so they can refinance their debt. Other cyclicals like Barrick, Potash Corp. and Magna International (liquid) also want the credit markets to reopen, but their motives are different. They want access to credit so they can expand their capacity, purchase distressed assets or do deals that are accretive to profits.

The hypersensitivity to financial strength has caught many investors off guard. Buying stocks when they're beaten up is a value investor's bread and butter, but it hasn't worked so far. Stocks with any balance sheet or liquidity issues have started out cheap, got cheaper, hit a point where there was no downside, became a screaming buy, and then...and then...became too risky to hold because of the threat of bankruptcy. The reward/risk measure gets better and better until it flips over.

Leverage and the credit crisis have dealt some companies a serious blow. But I'm not as discouraged as most people. Companies will recover and many will come out of the downturn in a stronger position than they went in.

In the meantime, there is a new greeting etiquette developing among business and investment people that reflects the importance today of a sound capital structure. A typical exchange on the Street goes something like this.

"Hey Jake, how are you doing?"

"Levered. How about you Fred?"

"Liquid. Hang in there buddy."