January 20, 2009 - Warren Buffett said that the two rules of investing are: #1 Don't lose money. #2 Don't forget rule number one. He then explained some more basics: When you buy a share do so as though you are becoming a partner in the business; Make sure you use the market to serve you, not to instruct you; And before buying be certain there is a sufficient margin of safety, a cushion of comfort between the price you are paying and the value of the company.

For example, Value investors look for low P/E (price to earnings) ratios, high cash positions, low debt, low price to book, preferably less than half, etc. They're looking for the margin of safety Buffett recommends.

Growth investors seek stocks that have growing earnings, the most revered being the ones increasing the bottom line by ever higher percentages. Those are very scarce these days.

Still other investors, often referred to as vultures, scour stocks for asset plays, trying to find balance sheets that don't fully reflect the value of the assets a company owns. At one time, when real estate was strong, it was often hidden in the value of a company's headquarters or its branches. Those days seem a far way away.

Now, howvever, no matter what investors use as their basis for analysis, the most important consideration is simply this: will the company survive the current economic brutality?

Before Washington Mutual, Fannie Mae, Freddie Mac and Countrywide, among many others, were allowed to fail, this question never came up. Certainly not appropriate for Fannie or Freddie. They were GSEs, government sponsored enterprises. Didn't that mean the government sponsored and backed them? That they couldn't possibly go out of business? Anyone owning the stock or the preferred found out the horrible answer to that question.

As for Lehman Brothers, WaMu and Countrywide, the assumption, and the wrong one, was that they were too big to fail. Certainly they wouldn't be allowed to go under. Their failure would hurt the credibility of large institutions, the trust Americans had in thrifts and lenders. Wrong again. They are gone. Countrywide has been swallowed by Bank of America. WaMu, after it went bankrupt, was bought by JP Morgan Chase but the WaMu shareholders got nothing. Lehman Brothers went out like a small fire in a hurricane.

So how can an investor know a company will survive? It's all about capital and the access to it. In other words, if a company can withstand several quarters of losses because it has the capital to continue past them, it will most likely make it. If it takes several years of losses to get through this economy, then very, very few companies will be left standing. The first and best indicator, then, is a firm's capital base.

That means how much equity it has, also known as shareholder's equity. Very little debt would also be good because even though interest rates are low, quarterly or semi-annual payments still need to be made. Those would normally flow to equity. If there are losses, they'll come from equity. The larger the equity position, relative to the cost of running the business, the better chances a company has to survive.

The second important factor is access to capital. That is, the ability to raise capital when needed. Large companies with strong balance sheets can do this now, especially in the debt markets. Not so much in the equity markets. No matter how large or strong the company is at the moment, it's almost impossible to raise equity unless it's a special arrangement like a private placement or preferred stock. Common equity is not available because investors appetite for risk is almost zero right now. They don't want just equity. They want some income (hence the preferreds have a chance). But only companies with strong balance sheets can give that.

Which companies come to mind that will most likely survive? They're the industry leaders. Names like Coca-Cola, Johnson and Johnson, Intel, Cisco, IBM, Microsoft, GE. The big names. Are they sexy? No way. They're mature, strong companies that have earnings engines that keep running, with lots of capital. Well, maybe they are sexy, to investors.

- Ted Allrich