Equities are bargain-basement cheap right now, but does that make them good deals? How do you distinguish between companies whose stocks prices have been trampled by the global slowdown/recession and those that are in or could be in real trouble?
Money managers maintain there are ways to determine which stocks are best positioned to rise with the tide of recovery — and which stocks should be avoided.
“The big mistake people make is buying into value traps,” says Charles Burbeck, an independent global portfolio manager based in London. “A big drop in price doesn’t mean the stock will go up in a bull market. In a bear market, there’s a transfer from old winners to new winners.”
Burbeck recommends dumping companies that have heavy debt or are counting on financing big capital investments through debt because they may not be able to get financing. Replace them, he suggests, with high-quality companies that have strong balance sheets and strong market positions, and that you know will be around in 10 years. For example, buy Tokyo-based Toyota Motor Corp. and not Detroit-based General Motors Corp.
Fred Sturm, chief investment officer with Mackenzie Financial Corp. in Toronto, emphasizes the need to make sure that, over the long term, a company’s basic franchise has not been injured. “Low-cost producers in established businesses that do not have liquidity concerns or banking issues should come out intact and live to crow another day,” he says. “But companies with a lot of debt require much more scrutiny.”
Understanding a company’s business so that you can evaluate its growth and earnings potential is a hallmark of the investment approach taken by John Arnold, chief investment officer and managing director with AGF International Investors Co. Ltd. in Dublin. It’s one he thinks works particularly well in troubled times.
Arnold wants to “see and touch” a company — to try out its products and services and see the business in operation. He prefers retail banks, which have customers inside and outside branches doing simple transactions, to investment banks, which are involved in using complicated financial instruments.
Peter O’Reilly, global money manager with I.G. Investment Management Ltd. in Dublin, also emphasizes the need to have a good understanding of “business models and risks in down cycles.”
But understanding a company’s business is only the first step. In the midst of a credit crisis, companies need strong balance sheets, achievable refinancing schedules and the ability to generate cash. That means, says O’Reilly, that you should “bulk up” with companies with good balance sheets.
In resources, for example, he recommends Husky Energy Inc., BP PLC and Royal Dutch Shell PLC vs “very speculative, ‘one-trick pony’ oilsands stocks.” In consumer stocks, he recommends focusing on companies that have cash on their balance sheets.
At New York-based Trilogy Global Advisors LLC, which manages a number of mutual funds for CI Investments Inc., the priority is on companies with balance sheets and refinancing schedules solid enough to get them through the next six to 12 months. After that, Trilogy’s money managers think economic recovery will be underway, says Bill Sterling, Trilogy’s CIO, and then financing will be easier to obtain.
Another factor to consider, say Clancy Ethans, CIO with Richardson Partners Financial Ltd. in Winnipeg, and Andy MacLean, RFPL’s director of private client investing in Toronto, is the sustainability of dividends. They suggest looking for dividend payout ratios — dividends as a percentage of net income — that are less than 60%, as well as a track record of maintaining dividends, especially through recessions.
Arnold, for one, expects dividend cuts. Life insurers, he says, will be able to maintain their dividends; but many global banks, as well as firms that are finding it hard to secure outside financing, will have to cut their dividends.
All of this advice makes sense but requires intensive research. For many advisors and their clients, that makes mutual funds or pooled funds very attractive in this economic environment. Once you have researched the funds’ managers —and you have decided you can trust them — you can leave the investment research to them.
Take the simple example of investment-grade corporate bonds. Many money managers think there will be a big opportunity this year to buy such bonds at distressed prices, then later sell them as their prices rise in the wake of accelerating equities markets. But to take advantage of that strategy, you will need to get the timing right — and the window of opportunity is expected to be narrow, probably only a few months. Knowing when to move takes both research and judgment. In addition, you need to be sure that the company whose bonds you are buying is not in danger of default or a downgrade by rating agencies — which also requires research.
@page_break@This makes a good argument for investing in a bond fund. The fund manager will not only do the research but will also diversify the fund, minimizing the risk that defaults will seriously hurt the fund. Once the credit crisis is over and healthy global economic growth resumes, you can suggest that clients sell the fund and return to buying individual bonds, if that is your and your clients’ preference.
The same argument applies to equities investments, especially because broad diversification provides safety in turbulent markets.
Of course, you can still recommend individual securities to your clients — as long as you are prepared to do the work.
Here’s a look at the factors that need to be considered when assessing possible investments:
> Balance Sheet. Debt as a percentage of assets is the first thing to consider. When you make the calculation, you should exclude goodwill and intangible assets from assets, says Ross Healy, president of Toronto-based Strategic Analysis Corp. They are not hard assets that can be sold, and their value can plunge in periods of economic weakness.
You should also look at the makeup of a company’s invested assets and see what exposure a company has to potentially toxic investments.
Within debt, you want to look particularly at short-term debt. If the company has debt maturing in the next year, it could have problems, should financing still be hard to find or expensive to procure.
You should also look at the company’s refinancing schedule to make sure there isn’t a large amount of debt coming due within the next few years. If the global slowdown/recession is deeper and more prolonged than expected, companies could still find it hard to get loans a few years hence.
In addition, find out when the company’s credit facilities with its bank expire. You want to be sure the company can continue operating if it can’t renew such facilities or has to renew only at very high interest rates.
Substantial cash balances are a big plus in an environment such as this one, as a firm can raid those reserves to carry on.
> Cash Flow. The safest companies in which to invest are those that generate sufficient cash to meet their obligations and continue operating without recourse to bank loans or other sources of financing. When calculating a company’s obligations, use “free cash flow” which includes capital investment requirements. That’s not part of the statement of cash flows, but it is essential to a company’s ability to carry on.
The amount of free cash flow is also a key factor in a company’s ability to continue paying dividends, so you’ll want to be sure the company is generating enough cash to continue paying dividends at its current rate.
> Industry Position. Evaluating a company’s position within its industry or sector is complicated because so many factors are involved. Questions to consider include:
> Do the company’s core products or services have substantial market share and are recognizable and well-regarded brands? Who are the firm’s competitors and how strong are they?
> Is the company a low-cost producer?
> Does the company have other advantages over competitors that can help it maintain or increase its market share?
> Does the company have diversity of products, services and markets, so that weaknesses in one product, service or region can be offset by strength elsewhere?
> What are the short-, medium- and long-term prospects for both the company and the industry/sector in which it operates?
> Has the company made recent acquisitions? If so, are there potential cost savings on the one hand or possible integration issues on the other?
> Does the company have expansion plans that it can finance at a reasonable cost?
> How strong is the management team? Do senior managers have a good, long-term record of generating earnings increases?
Careful research and attention to financial details will help you separate the wheat from the chaff. IE