Portfolio management: How we assess goodwill risk

As part of our portfolio management strategy, we put a lot of importance on the amount of goodwill that a company carries as an asset on its balance sheet.

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Goodwill is an accounting entry that reflects the price that the company paid for its acquisitions, minus the value of the tangible assets, like land and equipment, that it received as part of the acquisition. The term means “value as a going concern.”

However, goodwill acquired in an unwise acquisition can lose value overnight. When that happens, the company has to write it off against earnings. At worst, the company might have to write off most, if not all, of its goodwill.

If that writeoff wipes out most of the company’s shareholders’ equity, and/or most of a year’s earnings, it can devastate the share price. That’s a situation your portfolio management strategy should avoid at all costs.

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Portfolio management: The quality of a company’s goodwill is just as important as the quantity

Even though companies with high goodwill carry a greater risk of writedowns, your portfolio management strategy shouldn’t automatically dismiss these firms. CGI Group (symbol GIB.A on Toronto), one of the stocks we cover in our Successful Investor newsletter, provides an example of this kind of situation.

CGI Group is Canada’s largest provider of computer-outsourcing and information-technology services. It also operates in 15 other countries.

The company follows a two-pronged growth strategy it calls “Build and Buy.” The “Build” part refers to expanding relationships with its existing clients and attracting new ones. The company’s outsourcing contracts typically last 5 to 10 years. That gives CGI steady, predictable revenue streams, and lets it build customer loyalty.

Smart acquisition strategy helps cut the risk of a big writedown

The “Buy” part of CGI’s strategy involves making acquisitions. The company has made many acquisitions over the past few years. For example, it recently completed its $903-million U.S. takeover of Stanley Inc., which, like CGI, provides computer-outsourcing services. Most of Stanley’s clients are military and civilian agencies of the U.S. government.

In all, CGI’s purchases have raised its goodwill to $1.7 billion, or a high 40% of its $4.2-billion market cap.

However, CGI’s goodwill is less risky than it appears, because it focuses on small companies in a variety of industries and locations. It also focuses on firms that enhance its products or expand its geographic reach. That cuts the risk of a big writedown against earnings.

Long-term contracts further lower writedown risk

As well, customer relationships represent much of CGI’s goodwill. Because the company operates under long-term contracts, this kind of goodwill should be durable. As long as the company treats its customers well, it’s likely to hang on to most of them.

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