The Best Recession Stocks
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A MONEYWEEK SPECIAL INVESTMENT REPORT
Protect your portfolio from the slump
These are uncertain times. The worst of the financial crisis has passed for now. But no one knows for sure what to expect next. A few are predicting a storming recovery. But it’s hard to see how that can happen, with the banking system still dangerously fragile and unemployment yet to peak. A bigger – and even more uncertain question – is whether we’ll face deflation, inflation or perhaps even hyperinflation. On the one hand, the collapse in asset prices and the near-bankruptcy of much of the Western banking system means that credit will be squeezed for a long time to come. Combined with a growing number of jobless, that points to Japan-style deflation. On the other hand, the world’s central banks – in Britain and the US in particular – are pumping out money like there’s no tomorrow. They seemingly want to avoid deflation at any cost. But what happens if they succeed? Then inflation could start to take off. If they are too slow to pull out the vast sums of money they’ve pumped into the system, then inflation could get out of control, leading ultimately to a catastrophic currency collapse. Those are two very different outcomes. And for all we know, we could see both at various points along the cycle. Indeed, the only thing that it feels safe to say with any conviction is that we’ll be facing uncertainty for a long time to come. And that means one thing for investors – play it safe. Now, normally safety would mean developed government debt – gilts in the UK, Treasuries in the US. But there’s a problem here. As we noted already, western governments are hugely indebted due to their policies of printing as much money as possible to lessen the impact of the recession. But there’s only so much money-printing that a country can do before its creditors These stocks are usually known as “defensives”. That’s because they don’t depend as much on economic growth to keep selling their products – companies such as pharmaceutical firms, utilities and consumer goods firms, for example. These are the opposite to “cyclicals”, which suffer a great deal when economic growth falls – stocks such as airlines, certain types of retailer, and mining groups. The good news is that it’s precisely these defensive stocks that look cheap right now. The rally from the stock market’s March lows has almost entirely favoured cyclicals, as investors piled in, in the hope of a recovery. But with many disappointments still to come in the economy, we reckon this is somewhat premature. So we suspect that anyone buying defensives now can expect them to rebound as investors switch back into ‘safe’ havens. In this report, we look at some stocks that we like on this front. But more than that, we’ll equip you with the tools you need for your own investment analysis, so that you know what to look for when trying to decide whether a share is worth adding to your portfolio. Good luck with your investments!
“The worst of the financial crisis may have passed for now - but what happens next?”
start to worry about how it will pay them back. That would lead to a huge sell-off in government debt, driving yields higher (yields rise as prices fall). The US might be able to get away with running a massive deficit – for a time, at least. But Britain is by no means certain to get away with it. Already, some of the world’s biggest bond investors – including US investment management giant Pimco, which runs the world’s biggest bond fund – are voicing concerns about UK gilts. One fund manager at British investment group Standard Life has described buying UK government debt as like “playing Russian roulette”. So what should you buy? We think the best bet is to find solid companies. In the long run, a well-run company should grow alongside the economy. And in the hard times, it might take a few knocks, but as long as it can avoid bankruptcy, and - importantly – sustain its dividend, then you can still enjoy an income while you wait for the economy to recover.
John Stepek
email: [email protected]
In this report
3 Five defensive tips
News of a recovery has been somewhat exaggerated - so here are some of the stocks you should be buying now. Not all stock market value indicators work well when hard times hit. Here are the ones you should really be focusing on.
8 Pick survivors
9 Cash flow
The three key questions you should be asking about how a company gets its cash and what it does with it.
10 Two scores that can beat the slump Two oldfashioned measures that are making a comeback now that balance sheets matter again.
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A MONEYWEEK SPECIAL INVESTMENT REPORT
It looks like the worst of the gloom is blowing over…
… but appearances can be deceptive. How can you tell if a break in the clouds is the start of summer? John Stepek explains.
Recession fatigue has well and truly set in. As Sir Stuart Rose put it, people are “fed up with being fed up”. After a long daily diet of grim headlines and tales of horror about the financial crisis, anyone who has so far avoided losing their job might now be wondering what all the fuss was about. After all, it’s just a recession. It’s not World War Three; it’s not the Black Death. Comparisons with the Great Depression are by no means an exaggeration in terms of raw economic data. But the images conjured up by that era – of erstwhile Masters of the Universe reduced to selling apples on street corners, and families trying to eke out a living in the dustbowl – suggest a desperation that most people in the West simply don’t feel, thanks to modern innovations such as the welfare state. As Lucy Kellaway put it in the Financial Times recently: “the human spirit does not find it agreeable to stay down for too long”. Having accepted that we’re in recession, people are now deciding it’s really not that bad. Combine that with signs that the rate of collapse in the global economy is easing off, and it’s small wonder many have been tempted to throw off their tin hats and celebrate a new dawn. Goaded partly by the utter lack of interest available on most savings accounts, investors are piling back into the stockmarket. Some are even looking at getting back into the property market. So should you join them?
Look out below - there could be some nasty surprises still in store production rapidly in reaction to global demand falling off a cliff, so a boost from an element of restocking – as people buy things they now need to replace – seems likely in the coming year. But this crash happened so hard and fast that a fall in the rate of decline had to happen eventually. As Robin Aspinall of Halkin Services says, if something can’t get any worse, “it must get better”. More to the point, in the FT’s words, “signs of credit-market stress remain at high levels”. As for consumer spending, with unemployment still high and rising, it’s hard to see where consumers will find the money to support big increases in spending. So is the worst behind us? “In a word. No,” as the FT’s Martin Wolf put it back in April. As Wolf notes, we’ve barely started dealing with the problems that led 3 to the crash in the first place. In America, for example, “total private-sector debt rose from 112% of GDP in 1976 to 295% at the end of 2008. Financial sector debt alone jumped from 16% to 121% of GDP over this period.” Yet during 2008, “leverage rose still further”. So there remains a lot of saving and debt repayment to be done. Here in Britain, the picture’s just as weak. Lending growth is continuing to slow. A record of nearly 30,000 people in England and Wales went bankrupt in the first three months of this year, up 19% on the year before. And nearly 5,000 firms went bust during the same period, up by more than 50%. As Alan Tomlinson of insolvency practitioner Tomlinsons says, these “statistics firmly squash the notion that there are any green shoots of recovery out there.
The state we’re in
There are undoubtedly some signs of improvement in parts of the financial system. Credit conditions have relaxed somewhat, with various key lending rates now back to levels not seen since before the collapse of Lehman Brothers rocked the markets. Meanwhile, manufacturers have slashed
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Since last autumn many of the companies we are seeing have suffered significant drops in turnover they’ve been unable to replace.” And as James Ferguson points out in the box below, the banking crisis is still unfolding, so we can expect banks to continue keeping a tight rein on lending to both businesses and consumers. Governments are also becoming increasingly entrenched in their countries’ economic and financial systems. There are the waves of money being printed by central banks, while interest rates are abnormally low across the world. Meanwhile, from China to the US and Britain, the state is directing lending policies and deciding which firms (banks and car makers) are spared, and which go to the wall (retailers and small businesses). before you pile in, be warned – there are plenty of reasons to suspect that this isn’t a new bull market. For a start, it’s not unusual to have strong rallies within a wider bear market. As Albert Edwards of Société Générale points out, the “current pop” is “not dissimilar to the many bear market rallies between 1929-1933”, where hints of recovery led to “strong 25%+ rallies... this optimism was subsequently crushed.”
For another thing, in the first instance, the bounce was led by the same stocks that led the crash – financials in particular and also resource stocks. People are still acting on the basis that these stocks have fallen so far that they “must be cheap” by now – the same Waves of money are being printed by central banks attitude that bit investors during the time, and won’t be easy. As Wolf sums post-tech-bubble collapse. David up: “The brutal truth is that the financial Rosenberg of Merrill Lynch points out system is still far from healthy, the that “you know it’s a low-quality rally deleveraging of the private sectors of But as the influence of the public sector when the top 50 most heavily shorted expands, so the private sector – which stocks are the ones that outperform the highly indebted countries has not begun, ultimately drives growth – is squeezed most.” the needed rebalancing of global demand out. As Tim Price of PFP Wealth has barely even started, and, for all these Management notes, “whether businesses reasons, a return to sustained, private-sec- We also haven’t seen many of the signs that usually precede a new bull market. survive or fail during this recession will be tor-led growth probably remains a long way in the future.” a function not of the market, but of Simon Thompson in Investors Chronicle whether government wants them to. points to Russell Napier’s study of major That is not an economy that most entreUS market bottoms, Anatomy of the What about stocks? preneurs will want to play much part in, Bear. This found that at the end of a But a weak economy need not mean a and it throws the bear-market rally into a bear market there tends to be “a final declining stockmarket. Indeed, “the sharp and uncomfortable focus.” slump in share prices on low trading volgreen shoots are much more prevalent in umes (as investor selling becomes comthe market than in the economy”, says Reversing this position will take a long pletely exhausted) and confirmation of Edward Hadas on Breakingviews. But
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If this is a recession, why does it feel so good?
I was talking to the sixth form at a London school the other day about how serious the economic situation was and how it had all the signs of being the worst recession since World War II, writes James Ferguson. I could see the mere mention of the war had them immediately thinking ‘boring history lecture’ and I realised that, of course, none of their parents had lost their jobs. No family summer holidays abroad had been cancelled. No friends had had to leave the school, or move house. This recession may have decimated City bonuses and pushed unemployment up from 5.2% last May to 7.6% now, but it has left many unaffected. This is the feel-good recession (at least until you go and change your sterling into euros on holiday this summer). But harbingers of doom like myself aren’t worried about what this recession looks like right now. We’re looking at what has happened in the past when you have a banking crisis. And the first conclusion that positively leaps out at you is: this banking crisis, at least in terms of how it will affect the average person in the street, hasn’t even really begun yet. Why do I say that? Banking crises occur when there is a huge disruption to the distribution of credit in the economy and often reflects an over-extended banking system finding its insufficient capital eroded, or even wiped out, by losses relating to bad loans. Of course, we can’t know if the banks’ capital is going to get wiped out this time until after we’ve seen what default and, more importantly, recovery rates are like. But we can have a go at working it out using past banking-crisis recessions. The International Monetary Fund (IMF) has just finished two large studies investigating these topics. The first, the World Economic Outlook, investigates what financial crises look like. Its findings are sobering. Financial-crisis recessions are deeper than typical recessions, lasting about 40%-50% longer, and with a much slower recovery. In short, that means we can expect a minimum of 18 months of deeply negative GDP fol, lowed by three more years of only marginally positive GDP . The second IMF report, entitled the Global Financial Stability Report, then embarks on its own ‘stress test’ of the world’s banks. The report finds that, retained earnings aside, and working on loan loss assumptions garnered from previous recessions, the Western world’s banking systems will have eroded their capital bases to near zero by the end of next year.
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the bull market is then signalled by rising prices on expanding volumes”. But “volumes have been modest” during the current rally. So the short-term indicators aren’t good. Stocks face plenty of headwinds in the longer run too. Investors are going to have to absorb a lot more shares. Just as firms swapped equity for cheaper debt during the boom years, that process will reverse as firms, locked out by high debtraising costs, need to raise money through rights issues instead. As John Waples notes in The Sunday Times: “We still have dozens of fund-raisings to come, and billions of pounds that need to be refinanced in financial markets where the supply of new capital is thin on the ground.”
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do what smart investors always do: buy solid assets at good value prices. On that score, there are still opportunities out there. As James Ferguson points out in the box on page 4, during Japan’s slump, government bonds did well because of demand from banks. We would be less keen to buy gilts right now, simply because of the level of uncertainty over what the government and Bank of England might do next. However, there are other lessons we can learn from Japan’s experience. Andrew Lapthorne of Société Générale points out that buying stocks with high dividend yields and solid balance sheets produced strong returns. In particular, as David Stevenson highlights in Investors Chronicle, “picking stocks with a low price-to-book ratio versus their history proved to be a winning strategy”. More to the point, these are the sorts of stocks that have been underperfoming in the rally so far. So on the one hand they still look cheap, and on the other, if the rally continues, then they’ll get lifted along with the rest of the market. As Graham Secker at Morgan Stanley notes, there are “good absolute valuations on
Beware bear market rallies
What should you do now?
For many investors, this is the most dangerous period. They’ve already seen their net wealth hammered by the original crash. When the rally starts, they ignore it. But as it continues and stocks climb steadily higher, it becomes harder to watch those gains being made without taking part. Investors who’ve already been burnt by the original crash are particularly vulnerable – they start to hope that by taking part in one big rally they could make back some of their losses. So they pile in, usually just as the rally is coming to an end – and they get wiped out again. The good news is that you don’t have to stay out of the market. You just have to
The government’s presence in the markets will also have an impact. “As the invisible private hand of Adam Smith begins to resemble more and more the public fist of government,” says Bill Gross of bond fund manager Pimco, “then asset values should be negatively affected.” As an example, he points out that “if FedEx deserves a p/e of 12, wouldn’t the value of the [state-owned] US Post Office be substantially less”?
If this is a recession, why does it feel so good?
Continued from page 4
This rather shocking conclusion is the reason the IMF believes Western governments still have to inject huge sums into their banks. It’s also a stark reminder that while policy response has been fairly swift and substantial, the main requirement for fixing a banking bust is that the banks repair their balance sheets. So what does that involve? What banks have too much of after a credit bubble is risky loans, The ‘feel-good’ recession those that might default, as opposed to riskfree loans that can’t default, otherwise known as gilts. So what banks do once a crisis has hit is de-risk the profile of their balThese multi-year balance-sheet restructurings of the banks are ance sheets by replacing risky loans to the likes of you and me why banking-crisis recessions are more serious than ‘normal’ with risk-free assets in the form of gilts. So claims on governrecessions. The conclusion must be that the credit crunch that ment are set to rise sharply, while a matching drop in claims on beset the financial markets in 2007-2008 will turn into a multithe private sector will keep the credit crunch alive and well for year credit crunch on the high street from 2009 onwards. some years to come as banks continue to reduce lending. The reason this recession hasn’t yet hit the households of those school children I was talking to is not because they have Professor Tim Congdon charts many examples of this process been lucky, nor because the severity of this crisis has been at work during the balance-sheet rebuilding phase of bank overblown in the press. No, it’s mainly because, as far as the crises. In Japan, once the government injected capital into the person on the street is concerned, it hasn’t even begun yet.
banks and they started aggressively addressing their non-performing loans, bank lending fell at a compound rate of 2.6%. From 1997 to 2003, Japanese banks’ loan assets fell by nearly ¥70trn (around $700bn). Over the same period, their holdings of Japanese government bonds trebled from under ¥30trn to over ¥90trn – almost a straight yen-for-yen swap. Similarly, in the 1932-1937 period, the US banks bought 75% of all new government debt issued (around $10bn), while at the same time private-sector loans shrunk by 25%. And it was the same in Britain, where in just two years – 1932 and 1933 – gilt holdings rose 78% from £301m to £537m, during which time private-sector bank lending also fell.
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offer” – not to mention solid dividend payments. pharma giant GlaxoSmithKline (LSE: GSK, 1,120p), yielding 5.4%, and on a forward p/e of 9.4, look like a good play. There’s also a strong defensive case for holding something completely different – tobacco stocks. So-called ‘vice’ stocks, which include tobacco and gambling, have a good track record of performing during recessions. In fact, they have beatdon’t depend heavily on economic growth for their profits – people still need energy and water, even in a downturn. The average utility has also hiked its dividends per share every year since 2001. That’s longer than any other industry group, except healthcare companies. Better yet, judging by past experience, utilities aren’t just a safe haven in weak markets. They’ve done well in bull phases, too. During the five years to the market’s last peak in October 2007, utility stocks rose by 194%, compared with a 139% gain in the MSCI World index, says Bloomberg. Add in dividends, and utility stocks returned 257% over the period – 89% better than the wider index. Among others, we like National Grid (LSE: NG/, 557p), currently yielding 6.9% and trading on a forward p/e of 9.8 or water distributor United Utilities (LSE: UU/, 500.5p) which is on a forward p/e of 9, and yields 6..9% It’s not a traditionally defensive sector, but we still like the oil majors. Analysts seem to agree that their dividends won’t be threatened unless the oil price falls to $30 a barrel or less. With long-term demand for energy only set to rise, we think it’s a good idea to have exposure to the sector via a play such as BP (LSE: BP/, 491p), which yields 7.5% and trades on a forward p/e of 8.2.
Five stocks we like
There are plenty of stocks and sectors we like. This isn’t an exhaustive list, but it does include some of what we believe are the most attractive defensive plays at the moment. The pharmaceuticals sector has fallen out favour with investors over the past decade, and now the prospect of US healthcare reform, which could hit future profits, has been taking its toll on pharma share prices too. Investors fret that “expiring patents will put pressure on billions of dollars of blockbuster drug sales over the next few years”, says the FT’s Lex. “Yet the industry has been in a similar position before”. Drug makers pulled through the 1960s and 1970s “when research productivity plummeted” by creating “a series of new blockbusters and two decades of bumper profits”. What’s more, drug firms are still very good at churning out cash. Over the last year, the world’s top ten drug makers by revenue have produced over $78bn of free cash flow. Today, says Lex, “most big drug groups are well-run businesses with strong cash flows and solid long-term prospects – just the kinds of companies that strategic investors with an eye to the future should like”. That makes UK-listed
“There’s a lot of debt repayment still to do”
en the S&P 500 index by an average of 12% over the past six recessions, according to analysts at Merrill Lynch. So assuming you aren’t put off by the ethical issues around the sector, British American Tobacco (LSE: BATS, 1,766p) looks good. Over the long term, it has easily outshone the overall UK market indices in terms of performance. Yet it’s still a relatively cheap share, despite its ongoing ability to produce strong cash flow. On a forward p/e of 11.2, and a 5.4% 2009 yield, which is set to rise to 5.8% in 2010, the group remains a great value stock with a strong track record. Another sector well known for its defensive qualities is the utility sector. Utilities
applies to individual stocks: total returns from those with above-average dividend yields beat those with below-average In the long run, dividends are the key driver of returns on stocks. Since 1900, yields. In other words, you get better the S&P 500 has returned an average of returns from investing in stocks that are 6% or so a year in real (inflation-adjusted) already good yielders, than from hoping terms, says Capital Economics. But most that stocks that aren’t will grow their yield 1-year time horizon 5-year time horizon of that was down to reinvesting divisubstantially. The good news is that there Dividend yield Growth in real dividends Change in valuations dends. Capital gains on the original are plenty of high-yielding stocks around Jan Feb Mar Apr May Jun Jul investment account for just 1.5% a year. just now. But how sustainable are those dividends? There’s no doubt that in a deep recession dividends The longer you hold your shares, the more important diviwill be cut hard. Many stocks trade at high yields for good readends become. Over one year, around 60% of an investor’s son; their dividends will be annihilated and won’t be reboundreal return comes from changes in the stock price, says James ing soon. Recent examples include most of the banking sector Montier of Société Générale. But over five years, the combinaand the housebuilders. Avoiding traps such as these is really a tion of the initial dividend yield and the growth in dividends macroeconomic judgement: if the outlook for a sector is very accounts for 80% of returns. In short, unless you’re a trader, bleak, then it should be ignored regardless of how tempting the dividends matter a lot. That makes sense. A share is a claim on current yield looks. Beyond this, investors can apply a number a company’s assets and future cash flows. So in the long term, of criteria to stocks to check the sustainability of their dividends. share prices must be driven by how much hard cash the company returns to shareholders. In modern markets, the initial Lapthorne found that at the simplest level, selecting stocks with yield has been very important, says Montier’s colleague Andrew yields between 100-120% of the market average delivered good Lapthorne. From 1970 to the present, dividend growth beat inflaresults (very high-yielders are often distressed). For a more tion by an average of just 1.2 percentage points across the five complex screen, he found that checking the Piotroski score (a biggest equity markets (France, Germany, Japan, Britain and measure of the quality of the firm – see page 10) and balanceAmerica). The bulk (70%) of real returns from dividends came sheet strength (he used a complex test called the Merton from the initial yield. model, but the Altman Z score is a simpler alternative – also on page 10) gave the best results. Yet the commonly used earnings So investors should get the best returns by investing when divicover metric (earnings/dividend, which shows how well covdend yields are high, rather than by betting on growth. This also ered a dividend is by profits) didn’t improve performance.
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
Why dividends matter
Contribution to total real return depends on your time horizon – US data since 1871
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Source: SG Global Strategy Research
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Which sectors will survive the downturn?
by Tim Bennett Which industry sectors are best placed to withstand the recession? Accountancy group PricewaterhouseCoopers (PWC) has taken a look at how vulnerable 15 major British business sectors are to the downturn. The group’s head of macroeconomics, John Hawksworth, looked at three main features: cyclicality, current financial strength and growth potential. So which sectors should stay strong – and which should you avoid?
PWC Sector Vulnerability Index – top and bottom five sectors
Metal products Financial services Hotels, restaurants Engineering Transport, storage Non-food retail Food manufacture Sainsburys Chemicals (RHS) Tesco (LHS) Food retail Utilities
0 10 20 30 40 50
most vulnerable
least vulnerable
with each sector’s average longterm output growth trend over the past 20 years. Overall, British GDP has grown at around 0.65% per quarter over that period, so a number above that is a good start. For the business services sector, for example, it’s over 1%, whereas for oil and gas it’s –0.3%, due in part to dwindling North Sea output.
60 70 Source: PWC
1. Cyclicality
Analysts often describe sectors as either cyclical or defensive (counter-cyclical). Defensive sectors are those that have proved their ability to weather a previous downturn, whereas cyclicals tend to get dragged rapidly into the mire. But what is ‘cyclicality’? PWC splits it into two aspects. First there’s what they call the ‘economic beta’. This is the relative responsiveness of the output of a sector to overall changes in national gross domestic product (or wealth) over the last 20 years. In other words, this measures how tightly a sector is tied to the overall economic cycle. The higher the beta of a sector, the more sensitive it is to a sudden change in economic growth (GDP) and the greater its vulnerability to recession. So, for example, the post and telecoms sector has an economic beta of 2.3, meaning that for every 1% decrease in GDP, this sector sees, on average, a 2.3% drop in output. That sensitivity increases its final ‘vulnerability score’.
you might expect – that they are “less susceptible to the general economic cycle”.
Secondly, the p/e ratio was measured on the basis that, after the recent battering taken by share prices, anything rated above-average must be viewed by analysts as a decent bet.
2. Current financial strength
Hawksworth then reviewed key ratios for over 600 listed British firms, aiming to find which “can generate significant cash from either retained profits or external resources”. These have an edge, as not only are they well placed to ride out a recession, but they may also “be able to improve their market positions through organic growth and picking up assets at bargain prices”. The first of the four indicators used was decent profitability measured as return on capital employed (ROCE) – financial
Lastly, the study reviewed the ratio of exports to total domestic output. The aim was to expose export-intensive sectors. A high score is bad news, says PWC, as in a downturn, “exports tend to be more volatile than domestic demand”.
Winners and losers
Metal products emerged as the worst sector. It is the most vulnerable to the downturn, says the report, due to a combination of high cyclicality and volatility (equity beta 1.6), limited potential for future growth and the lowest level of interest cover of any sector, despite modest gearing levels. Financial services comes a close second, followed by hotels and restaurants. So you should also steer clear of any firm that employs either star bankers or celebrity chefs.
“Steer clear of firms with star bankers or celebrity chefs”
services firms came bottom on this measure. Next, the ability to service existing debt and even raise more was tested using gearing (the ratio of debt to equity funding from the balance sheet) and interest cover (profit before interest as a multiple of one year’s interest expense). Chemicals firms scored well here. Lastly, a high ‘quick’ ratio (current assets as a multiple of current liabilities) helps to show whether a firm has decent shortterm liquidity.
Next, there’s the ‘equity beta’. This focuses on how sensitive the shares within a particular sector are to overall stockmarket movements. A high beta on this measure (anything above one, says PWC) points to greater volatility and a bigger risk that the sector will be disproportionately pummelled as the economy tanks. On this measure, for example, utilities scored 0.8, which suggests – as
3. Growth potential
Here, PWC took three separate measures of long-term growth potential, starting 7
However, PWC likes chemicals, a sector dominated in Britain by big pharma firms. In the short term, they can rely on a “steady flow of orders from the NHS”. We like GlaxoSmithKline (LSE:GSK). Next come food retailers such as Tesco (LSE: TSCO) and utility firms such as National Grid (LSE:NG). As the report concludes, “electricity, gas and water suppliers are more affected by regulatory regimes and weather conditions than short-term economic fluctuations”, making them a relatively safe shelter as the storm rages. First published in March 2009
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How to tell gems from dross
Some stocks are cheap for a reason. Others are just plain cheap. But how to tell which is which? Tim Bennett explains
How can you separate quality stocks from those destined for the scrap heap? And which performance indicators can you trust in a downturn? Two classic tests for a cheap stock are a low price/earnings ratio (p/e) and a high dividend yield. Falling equity markets quickly throw up ‘buys’ on both measures. Take a stock with a share price of 100p, a full-year dividend of 5p per share, and forecast earnings per share for the next year of 10p. The share price is 10 times forecast earnings, so the p/e is 10, while the dividend yield – the annual dividend as a percentage of the share price – is 5% (5p/100p x 100%). But if the share price then collapses to 50p, with earnings and dividends unchanged, the p/e halves to five (50p/10p), while the yield doubles to 10% (5p/50p x 100%). On the strength of those numbers alone, the stock now looks much cheaper in relation to forecast earnings – a low p/e – and also offers a much higher income return. But is it a buy? Not necessarily. The sudden share price falls that push up the yield often reflect doubts about both future earnings and a firm’s ability to make its next dividend payment. So dividend yields well above the return available on far less risky government bonds or cash accounts often turn out to be honey-traps. That’s especially true of firms that suffer from high ‘operational gearing’. it, given that the interest charge is no longer covered (40/50 is just 0.8), even though the firm still generates a positive return on its equity capital of 8% (40/500). Unfair? Perhaps, but cashstrapped banks are targeting everything from housebuilders to hedge funds that lack solvency, for which low interest cover and high gearing are classic tests.
Solvency and liquidity
Even a solvent firm can go bust for lack of liquidity. Imagine you need to borrow £50 in a hurry because you owe it to a mate who wants it back and you don’t have the cash. That’s a liquidity crisis. But if you have a watch worth at least £100 you are technically ‘solvent’ – you have an asset worth at least what you owe. You could solve your liquidity problem by taking it to a pawn-broker and handing it over as collateral in return for say £80 (a broker will always apply a ‘haircut’), £50 of which goes to your mate. Many large, solvent (meaning they carry modest levels of financial gearing) firms have still been faced with liquidity problems. That’s because they find it increasingly hard to repay their creditors as their own suppliers run into cash-flow difficulties and delay payment. And a sudden lack of liquidity can finish any firm. That’s why insolvency group Begbies Traynor has so many retailers on a “critical watch list”.
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You have to look closely to find hidden gems turnover. So, the new profit figure is just £1 (£90 – £80 – £9). That’s a drop of 90%. Businesses with this high fixed-cost structure can be found in every high street.
Gearing – debt invites disaster
Next, we have the other brand of gearing – ‘financial’. Like homeowners, companies can be earning a decent living but still collapse under a heap of debt. Gearing and, better still, interest cover reveal how likely this is. Take a simple
High fixed costs can hurt
Operational gearing explains why weaker airlines, shops and restaurants fold so quickly in a downturn. In short, it’s because their profit margins are very sensitive to even a small dip in sales. That’s down to high fixed costs. Take a business with sales of £100, fixed costs (such as staff and property) of £80 and variable costs (such as light, heat and stock for resale) of £10. Profit is £10 (£100 of sales – £80 of fixed costs – £10 of variable costs). The business is said to be highly operationally geared since fixed costs are a very high chunk (80/90 or 89%) of total costs. Assume sales fall 10% to £90. The fixed costs are just that – fixed. Variable costs, however, usually fall in line with
“A sudden lack of liquidity can finish a company”
company with assets of £1,000. Say it’s funded 50% with debt, costing 10%, and 50% with shareholders’ equity (shares) and makes a profit before interest charges of £80. Gearing – the relationship between debt and equity funding – is 100% (£500/£500). Meanwhile, interest cover – the number of times profit covers the interest charge – is 1.6 times (80/50). Overall the return on shareholder equity is a healthy 16% (80/500). But that low interest cover creates a big risk. Say profits halve to £40. The now-worried bank that provided the original loan could pull 8
Working capital management
So for an investor, evidence of ‘working capital management’ is key. Get it wrong and even a profitable company can face a liquidity crisis. Say a firm makes £800 of cash purchases and £1,000 of cash sales over a month. That’s a profit of £200 at the end of the month and cash in the bank of £200. However, introduce credit terms and the cash (‘liquidity’) position changes. If the same firm, keen to expand, decided to sell 75% of its stock on three months’ credit and agreed similar terms for just 25% of its purchases from suppliers, then under accounting rules the total profit is still £200 (total sales less total purchases). But the company now has a cash overdraft at the end of the first month of £350 (cash received is 25% of £1,000 = £250; while
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cash paid out is 75% of £800, or £600. And £250 – £600 is –£350). Keep that up each month without an agreed overdraft and the company could be put out of business by a trigger-happy lender, even although it is profitable. It’s largely thanks to good working capital management that the likes of Arcadia’s Philip Green and Tesco’s Terry Leahy can fund rapid expansion, even as times get tough for many of their rivals. profits – analysts call this ‘cash cover’. Low cash cover is a classic danger sign that revenue is being booked aggressively and cash not collected. Then check the cash-flow statement for any major spending during the year, especially on long-term or fixed assets. Are these replacements or new assets? If new, where did the finance come from to pay for them? Also look at the stock and receivables lines in the balance sheet – if these are growing faster than sales it may suggest that the company is struggling to shift stock, or is offering more and more generous terms to customers to stay in business – both of which are bad news. At the very least keep an eye on the price to free cash flow ratio (the current share price as a multiple of operating cash flow, minus non-discretionary costs – these usually include interest payments and essential capital expenditure). Be wary of stocks that carry a low p/e ratio but a high P/FCF ratio (a sign the stock is actually expensive, even high risk, when hard cash flow is taken into account). For more on cash flow, see the box below.
Cash flow – avoid naked swimmers
Another crucial thing to remember is that you can’t just rely on profits. Here’s why. Take a car company as an example. If it sells a £10,000 model, then even if it does so on credit - however generous the terms - it gets to book the sale immediately in a profit and loss account. So everything looks fine. But what if the end customer delays payment or even goes bust? Cash flow is much harder to fudge – if a customer pays, a firm records a £10,000 inflow, but until then, it books nothing. So how do you test for strong cash flow? A good start is checking whether a firm
Keep an eye on cash flow has ‘net cash’ (rather than ‘net debt’), so balance-sheet cash should exceed interestbearing debt. Then check the relationship between operating profit (in the profit and loss account) and operating cash flow (from the cash-flow statement). You want cash flow to match, or ideally exceed,
Three questions you must ask about cash flow
There’s more to a safe company than low borrowing or gearing ratios - you have to dig out a firm’s cash-flow statement too. This 12-month summary of a company’s cash inflows and outflows will enable you to answer three key questions. firm needs to spend on new long-term assets to stay in business. The first two can be found on the main cash-flow statement. The last one can’t, but may be approximated by using the annual deprecation charge – an accounting estimate of one year’s wear and tear. Free cash flow should be positive and ideally consistent with past years, allowing for changes in activity. If sales have fallen by, say, 10%, free cash flow will probably have fallen too – but not by 50%. Firms then have a choice about how they apply free cash flow. Tesco has grown rapidly in the past, using its free cash flows to buy new freehold sites. But if a firm has lots of free cash flow yet isn’t expanding or paying it out as a dividend, be concerned. What return is it generating that justifies your continued support? Also crucial to most investors is the relationship between free cash flow and the equity dividend. Be worried if free cash flow doesn’t cover the dividend at least twice, as future payouts might be at risk.
1. Where does the cash come from?
Just as you can supplement a salary by remortgaging or flogging the family silver, a firm can boost short-term cash flow by borrowing, or selling assets. But there are only so many assets you can sell. Without a regular income, a firm will quickly run out of cash. So find the most important number near the top of the cash-flow statement: ‘cash flow from operating activities’. This shows how much cash a firm makes from its core business activity. A negative is a huge red flag. Then check back a few years. Highly volatile operating cash flows can suggest trouble – Enron was a classic example. A firm can also enhance operating cash flows by delaying payments to suppliers, just before the financial year-end. Look at the note that supports the cash-flow figure, in particular the line on ‘change in creditors’. If the number has jumped without a corresponding rise in activity – ‘cost of sales’ – in the profit and loss account, be suspicious. Also, compare the firm’s ‘operating profit’ to operating cash flow. Big variations, or an operating profit not at least matched by a similar amount of operating cash flow, are both warning signs.
3. How is the firm financed?
The final area to look at is the ‘cash flows from financing activities’ section. Just as you shouldn’t extend your mortgage to pay for day-to-day living, so for firms, short-term finance pays for short-term activities (management of customers, trading stock and suppliers, for example) and longterm finance pays for investment. A typical bankruptcy candidate will raise long-term finance as new debt or equity, then use it just to keep trading. So compare the total raised as debt or equity in the ‘cash flows from financing activities’ section and the amount being spent on new assets in the ‘cash flows from investing activities’ above it. A big mismatch with no explanation from directors is another warning sign.
2. Where does all this cash go?
Next, look at where all the operating cash flow goes. First, check the ‘free cash flow’. Take ‘cash flow from operating activities’ and deduct non-discretionary spending, such as interest paid to lenders and banks, tax paid and whatever the
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A MONEYWEEK SPECIAL INVESTMENT REPORT
How Z scores can help you beat the slump
by Tim Bennett Before the credit crunch struck, corporate solvency was the last thing on investors’ minds. Cash was easy to come by and consumers were spending freely. But those days are long gone. And this newly-cautious environment has led to the rehabilitation of out-of-favour investment measures, such as Edward Altman’s Z score. The system was originally devised back in the 1960s to warn investors about firms at risk of going bust. But it can also help you find the sectors and stocks with the strongest balance sheets. In other words, the ones that are best able to withstand the downturn. to its size. Basically, it demonstrates how much value for money a firm is getting from its assets. More efficient companies tend to be better placed to thrive during hard times. In Vodafone’s case, the relevant figures are the operating profit of £10,047m and total long- and short-term assets, which add up to £127,270m. Vodafone this is £35,478m.
5. Market cap to total liabilities
This offers a quick test of how far the company’s assets can decline before the firm becomes technically insolvent – the point at which its liabilities exceed its assets. For Vodafone, the market cap on 4 August 2008, says Digitallook.com, was £72.18bn, while total liabilities (that’s the short and long-term liabilities combined) come to £50,799m. You could calculate all of these ratios and then weight them by hand. But it’s faster to get the relevant figures from the balance sheet and profit and loss, then feed them into an online Z score calculator, such as the one at Creditguru.com/CalcAltZ.shtml. Using the figures from the example above gives Vodafone a Z-score of 0.364.
2. Retained earnings to total assets
This indicates the cumulative profitability of the firm, again compared to its overall size. Shrinking profitability is obviously a warning sign. This measure can also indicate how highly geared a company is. High retained profits suggest that a firm may have financed its assets through profits rather than debt. Vodafone doesn’t have any retained profits; rather it has –£81,980m of retained losses.
How Z scores work
Altman’s model is based on analysing the financial strength of a company using five ratios built on key numbers mainly taken from a firm’s balance sheet, along with a few from the profit and loss account. Each ratio is then weighted to reflect its relative importance before the five are added together to generate a Z score, usually a single digit figure. Here’s how it works. We’ve used figures drawn from the income statement and balance sheet from the 2008 accounts of FTSE 100 firm Vodafone, purely for illustrative purposes. The ratios are listed in order of importance.
What does it all mean? 3. Working capital to total assets
This compares liquid assets, called “working capital” or “net current assets”, to the total long (“fixed”) and short-term (“current”) assets from the balance sheet. A firm in trouble will usually experience shrinking liquidity by this measure. In other words, as sales fall or costs rise, the amount of easily available cash will fall. Vodafone’s balance sheet at 31 March 2008 shows current assets of £8,724m, minus current liabilities of £21,973m, giving working capital of –£13,249m. In this case, you’d want to avoid Vodafone (though bear in mind these are the 2008 figures). The weaker the Altman score, in particular a reading around or below about 1.6, the greater the chance of a firm suffering financial distress within the next two years. While no one is suggesting Vodafone is about to go bust, Graham Secker of Morgan Stanley points out that firms with a Z score of below one have always tended to underperform the market, “particularly in recessionary periods”. Taking the period from 1990 to 2007, the average compound annual growth rate (CAGR) for these stocks was –3.3% against 4.1% for the median stock in the market. On the other hand, stocks scoring between 2.5 and 3 on the Z score provided a CAGR of 6.3%.
1. EBIT to total assets
This is the most heavily weighted – in other words, the most important – component of the Z score. EBIT is earnings before interest and tax, or “operating profit”. This ratio shows how productive a company is in earnings terms, relative
4. Sales to total assets
This is a measure of how effectively the firm uses its assets to generate sales. This uses the turnover figure at the top of the profit and loss statement – for
Piotroski score: what makes a good balance sheet?
There are many ways to stress test a balance sheet, which is “the first hurdle to overcome for any investments before value or growth considerations are taken into account” says Teun , Draaisma of Morgan Stanley. One of the most comprehensive and better-known is the Piotroski score. Devised by a University of Chicago accounting professor, it's a simple nine-step method that rates a stock primarily using balance-sheet criteria, backed up with decent cash flow and earnings strength. The score for each test is either one if a firm passes, or zero if it fails. Combine all nine and you get a total score between zero and nine. The nine Piotroski hurdles are as follows (score one for “yes” and zero for “no”): positive net income; positive cash flow; operating cash flow above net income; a lower ratio of debt to total assets than the previous year; increased working capital (or “net current assets” on a balance sheet); higher asset turnover (sales/total assets indicates productivity); higher return on assets than the previous year; the same or fewer shares outstanding than a year ago; and, finally, rising profit margins. Stocks with a score of five or more have financial strength.
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Protect your portfolio from the slump
These are uncertain times. The worst of the financial crisis has passed for now. But no one knows for sure what to expect next. A few are predicting a storming recovery. But it’s hard to see how that can happen, with the banking system still dangerously fragile and unemployment yet to peak. A bigger – and even more uncertain question – is whether we’ll face deflation, inflation or perhaps even hyperinflation. On the one hand, the collapse in asset prices and the near-bankruptcy of much of the Western banking system means that credit will be squeezed for a long time to come. Combined with a growing number of jobless, that points to Japan-style deflation. On the other hand, the world’s central banks – in Britain and the US in particular – are pumping out money like there’s no tomorrow. They seemingly want to avoid deflation at any cost. But what happens if they succeed? Then inflation could start to take off. If they are too slow to pull out the vast sums of money they’ve pumped into the system, then inflation could get out of control, leading ultimately to a catastrophic currency collapse. Those are two very different outcomes. And for all we know, we could see both at various points along the cycle. Indeed, the only thing that it feels safe to say with any conviction is that we’ll be facing uncertainty for a long time to come. And that means one thing for investors – play it safe. Now, normally safety would mean developed government debt – gilts in the UK, Treasuries in the US. But there’s a problem here. As we noted already, western governments are hugely indebted due to their policies of printing as much money as possible to lessen the impact of the recession. But there’s only so much money-printing that a country can do before its creditors These stocks are usually known as “defensives”. That’s because they don’t depend as much on economic growth to keep selling their products – companies such as pharmaceutical firms, utilities and consumer goods firms, for example. These are the opposite to “cyclicals”, which suffer a great deal when economic growth falls – stocks such as airlines, certain types of retailer, and mining groups. The good news is that it’s precisely these defensive stocks that look cheap right now. The rally from the stock market’s March lows has almost entirely favoured cyclicals, as investors piled in, in the hope of a recovery. But with many disappointments still to come in the economy, we reckon this is somewhat premature. So we suspect that anyone buying defensives now can expect them to rebound as investors switch back into ‘safe’ havens. In this report, we look at some stocks that we like on this front. But more than that, we’ll equip you with the tools you need for your own investment analysis, so that you know what to look for when trying to decide whether a share is worth adding to your portfolio. Good luck with your investments!
“The worst of the financial crisis may have passed for now - but what happens next?”
start to worry about how it will pay them back. That would lead to a huge sell-off in government debt, driving yields higher (yields rise as prices fall). The US might be able to get away with running a massive deficit – for a time, at least. But Britain is by no means certain to get away with it. Already, some of the world’s biggest bond investors – including US investment management giant Pimco, which runs the world’s biggest bond fund – are voicing concerns about UK gilts. One fund manager at British investment group Standard Life has described buying UK government debt as like “playing Russian roulette”. So what should you buy? We think the best bet is to find solid companies. In the long run, a well-run company should grow alongside the economy. And in the hard times, it might take a few knocks, but as long as it can avoid bankruptcy, and - importantly – sustain its dividend, then you can still enjoy an income while you wait for the economy to recover.
John Stepek
email: [email protected]
In this report
3 Five defensive tips
News of a recovery has been somewhat exaggerated - so here are some of the stocks you should be buying now. Not all stock market value indicators work well when hard times hit. Here are the ones you should really be focusing on.
8 Pick survivors
9 Cash flow
The three key questions you should be asking about how a company gets its cash and what it does with it.
10 Two scores that can beat the slump Two oldfashioned measures that are making a comeback now that balance sheets matter again.
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It looks like the worst of the gloom is blowing over…
… but appearances can be deceptive. How can you tell if a break in the clouds is the start of summer? John Stepek explains.
Recession fatigue has well and truly set in. As Sir Stuart Rose put it, people are “fed up with being fed up”. After a long daily diet of grim headlines and tales of horror about the financial crisis, anyone who has so far avoided losing their job might now be wondering what all the fuss was about. After all, it’s just a recession. It’s not World War Three; it’s not the Black Death. Comparisons with the Great Depression are by no means an exaggeration in terms of raw economic data. But the images conjured up by that era – of erstwhile Masters of the Universe reduced to selling apples on street corners, and families trying to eke out a living in the dustbowl – suggest a desperation that most people in the West simply don’t feel, thanks to modern innovations such as the welfare state. As Lucy Kellaway put it in the Financial Times recently: “the human spirit does not find it agreeable to stay down for too long”. Having accepted that we’re in recession, people are now deciding it’s really not that bad. Combine that with signs that the rate of collapse in the global economy is easing off, and it’s small wonder many have been tempted to throw off their tin hats and celebrate a new dawn. Goaded partly by the utter lack of interest available on most savings accounts, investors are piling back into the stockmarket. Some are even looking at getting back into the property market. So should you join them?
Look out below - there could be some nasty surprises still in store production rapidly in reaction to global demand falling off a cliff, so a boost from an element of restocking – as people buy things they now need to replace – seems likely in the coming year. But this crash happened so hard and fast that a fall in the rate of decline had to happen eventually. As Robin Aspinall of Halkin Services says, if something can’t get any worse, “it must get better”. More to the point, in the FT’s words, “signs of credit-market stress remain at high levels”. As for consumer spending, with unemployment still high and rising, it’s hard to see where consumers will find the money to support big increases in spending. So is the worst behind us? “In a word. No,” as the FT’s Martin Wolf put it back in April. As Wolf notes, we’ve barely started dealing with the problems that led 3 to the crash in the first place. In America, for example, “total private-sector debt rose from 112% of GDP in 1976 to 295% at the end of 2008. Financial sector debt alone jumped from 16% to 121% of GDP over this period.” Yet during 2008, “leverage rose still further”. So there remains a lot of saving and debt repayment to be done. Here in Britain, the picture’s just as weak. Lending growth is continuing to slow. A record of nearly 30,000 people in England and Wales went bankrupt in the first three months of this year, up 19% on the year before. And nearly 5,000 firms went bust during the same period, up by more than 50%. As Alan Tomlinson of insolvency practitioner Tomlinsons says, these “statistics firmly squash the notion that there are any green shoots of recovery out there.
The state we’re in
There are undoubtedly some signs of improvement in parts of the financial system. Credit conditions have relaxed somewhat, with various key lending rates now back to levels not seen since before the collapse of Lehman Brothers rocked the markets. Meanwhile, manufacturers have slashed
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Since last autumn many of the companies we are seeing have suffered significant drops in turnover they’ve been unable to replace.” And as James Ferguson points out in the box below, the banking crisis is still unfolding, so we can expect banks to continue keeping a tight rein on lending to both businesses and consumers. Governments are also becoming increasingly entrenched in their countries’ economic and financial systems. There are the waves of money being printed by central banks, while interest rates are abnormally low across the world. Meanwhile, from China to the US and Britain, the state is directing lending policies and deciding which firms (banks and car makers) are spared, and which go to the wall (retailers and small businesses). before you pile in, be warned – there are plenty of reasons to suspect that this isn’t a new bull market. For a start, it’s not unusual to have strong rallies within a wider bear market. As Albert Edwards of Société Générale points out, the “current pop” is “not dissimilar to the many bear market rallies between 1929-1933”, where hints of recovery led to “strong 25%+ rallies... this optimism was subsequently crushed.”
For another thing, in the first instance, the bounce was led by the same stocks that led the crash – financials in particular and also resource stocks. People are still acting on the basis that these stocks have fallen so far that they “must be cheap” by now – the same Waves of money are being printed by central banks attitude that bit investors during the time, and won’t be easy. As Wolf sums post-tech-bubble collapse. David up: “The brutal truth is that the financial Rosenberg of Merrill Lynch points out system is still far from healthy, the that “you know it’s a low-quality rally deleveraging of the private sectors of But as the influence of the public sector when the top 50 most heavily shorted expands, so the private sector – which stocks are the ones that outperform the highly indebted countries has not begun, ultimately drives growth – is squeezed most.” the needed rebalancing of global demand out. As Tim Price of PFP Wealth has barely even started, and, for all these Management notes, “whether businesses reasons, a return to sustained, private-sec- We also haven’t seen many of the signs that usually precede a new bull market. survive or fail during this recession will be tor-led growth probably remains a long way in the future.” a function not of the market, but of Simon Thompson in Investors Chronicle whether government wants them to. points to Russell Napier’s study of major That is not an economy that most entreUS market bottoms, Anatomy of the What about stocks? preneurs will want to play much part in, Bear. This found that at the end of a But a weak economy need not mean a and it throws the bear-market rally into a bear market there tends to be “a final declining stockmarket. Indeed, “the sharp and uncomfortable focus.” slump in share prices on low trading volgreen shoots are much more prevalent in umes (as investor selling becomes comthe market than in the economy”, says Reversing this position will take a long pletely exhausted) and confirmation of Edward Hadas on Breakingviews. But
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If this is a recession, why does it feel so good?
I was talking to the sixth form at a London school the other day about how serious the economic situation was and how it had all the signs of being the worst recession since World War II, writes James Ferguson. I could see the mere mention of the war had them immediately thinking ‘boring history lecture’ and I realised that, of course, none of their parents had lost their jobs. No family summer holidays abroad had been cancelled. No friends had had to leave the school, or move house. This recession may have decimated City bonuses and pushed unemployment up from 5.2% last May to 7.6% now, but it has left many unaffected. This is the feel-good recession (at least until you go and change your sterling into euros on holiday this summer). But harbingers of doom like myself aren’t worried about what this recession looks like right now. We’re looking at what has happened in the past when you have a banking crisis. And the first conclusion that positively leaps out at you is: this banking crisis, at least in terms of how it will affect the average person in the street, hasn’t even really begun yet. Why do I say that? Banking crises occur when there is a huge disruption to the distribution of credit in the economy and often reflects an over-extended banking system finding its insufficient capital eroded, or even wiped out, by losses relating to bad loans. Of course, we can’t know if the banks’ capital is going to get wiped out this time until after we’ve seen what default and, more importantly, recovery rates are like. But we can have a go at working it out using past banking-crisis recessions. The International Monetary Fund (IMF) has just finished two large studies investigating these topics. The first, the World Economic Outlook, investigates what financial crises look like. Its findings are sobering. Financial-crisis recessions are deeper than typical recessions, lasting about 40%-50% longer, and with a much slower recovery. In short, that means we can expect a minimum of 18 months of deeply negative GDP fol, lowed by three more years of only marginally positive GDP . The second IMF report, entitled the Global Financial Stability Report, then embarks on its own ‘stress test’ of the world’s banks. The report finds that, retained earnings aside, and working on loan loss assumptions garnered from previous recessions, the Western world’s banking systems will have eroded their capital bases to near zero by the end of next year.
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the bull market is then signalled by rising prices on expanding volumes”. But “volumes have been modest” during the current rally. So the short-term indicators aren’t good. Stocks face plenty of headwinds in the longer run too. Investors are going to have to absorb a lot more shares. Just as firms swapped equity for cheaper debt during the boom years, that process will reverse as firms, locked out by high debtraising costs, need to raise money through rights issues instead. As John Waples notes in The Sunday Times: “We still have dozens of fund-raisings to come, and billions of pounds that need to be refinanced in financial markets where the supply of new capital is thin on the ground.”
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do what smart investors always do: buy solid assets at good value prices. On that score, there are still opportunities out there. As James Ferguson points out in the box on page 4, during Japan’s slump, government bonds did well because of demand from banks. We would be less keen to buy gilts right now, simply because of the level of uncertainty over what the government and Bank of England might do next. However, there are other lessons we can learn from Japan’s experience. Andrew Lapthorne of Société Générale points out that buying stocks with high dividend yields and solid balance sheets produced strong returns. In particular, as David Stevenson highlights in Investors Chronicle, “picking stocks with a low price-to-book ratio versus their history proved to be a winning strategy”. More to the point, these are the sorts of stocks that have been underperfoming in the rally so far. So on the one hand they still look cheap, and on the other, if the rally continues, then they’ll get lifted along with the rest of the market. As Graham Secker at Morgan Stanley notes, there are “good absolute valuations on
Beware bear market rallies
What should you do now?
For many investors, this is the most dangerous period. They’ve already seen their net wealth hammered by the original crash. When the rally starts, they ignore it. But as it continues and stocks climb steadily higher, it becomes harder to watch those gains being made without taking part. Investors who’ve already been burnt by the original crash are particularly vulnerable – they start to hope that by taking part in one big rally they could make back some of their losses. So they pile in, usually just as the rally is coming to an end – and they get wiped out again. The good news is that you don’t have to stay out of the market. You just have to
The government’s presence in the markets will also have an impact. “As the invisible private hand of Adam Smith begins to resemble more and more the public fist of government,” says Bill Gross of bond fund manager Pimco, “then asset values should be negatively affected.” As an example, he points out that “if FedEx deserves a p/e of 12, wouldn’t the value of the [state-owned] US Post Office be substantially less”?
If this is a recession, why does it feel so good?
Continued from page 4
This rather shocking conclusion is the reason the IMF believes Western governments still have to inject huge sums into their banks. It’s also a stark reminder that while policy response has been fairly swift and substantial, the main requirement for fixing a banking bust is that the banks repair their balance sheets. So what does that involve? What banks have too much of after a credit bubble is risky loans, The ‘feel-good’ recession those that might default, as opposed to riskfree loans that can’t default, otherwise known as gilts. So what banks do once a crisis has hit is de-risk the profile of their balThese multi-year balance-sheet restructurings of the banks are ance sheets by replacing risky loans to the likes of you and me why banking-crisis recessions are more serious than ‘normal’ with risk-free assets in the form of gilts. So claims on governrecessions. The conclusion must be that the credit crunch that ment are set to rise sharply, while a matching drop in claims on beset the financial markets in 2007-2008 will turn into a multithe private sector will keep the credit crunch alive and well for year credit crunch on the high street from 2009 onwards. some years to come as banks continue to reduce lending. The reason this recession hasn’t yet hit the households of those school children I was talking to is not because they have Professor Tim Congdon charts many examples of this process been lucky, nor because the severity of this crisis has been at work during the balance-sheet rebuilding phase of bank overblown in the press. No, it’s mainly because, as far as the crises. In Japan, once the government injected capital into the person on the street is concerned, it hasn’t even begun yet.
banks and they started aggressively addressing their non-performing loans, bank lending fell at a compound rate of 2.6%. From 1997 to 2003, Japanese banks’ loan assets fell by nearly ¥70trn (around $700bn). Over the same period, their holdings of Japanese government bonds trebled from under ¥30trn to over ¥90trn – almost a straight yen-for-yen swap. Similarly, in the 1932-1937 period, the US banks bought 75% of all new government debt issued (around $10bn), while at the same time private-sector loans shrunk by 25%. And it was the same in Britain, where in just two years – 1932 and 1933 – gilt holdings rose 78% from £301m to £537m, during which time private-sector bank lending also fell.
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offer” – not to mention solid dividend payments. pharma giant GlaxoSmithKline (LSE: GSK, 1,120p), yielding 5.4%, and on a forward p/e of 9.4, look like a good play. There’s also a strong defensive case for holding something completely different – tobacco stocks. So-called ‘vice’ stocks, which include tobacco and gambling, have a good track record of performing during recessions. In fact, they have beatdon’t depend heavily on economic growth for their profits – people still need energy and water, even in a downturn. The average utility has also hiked its dividends per share every year since 2001. That’s longer than any other industry group, except healthcare companies. Better yet, judging by past experience, utilities aren’t just a safe haven in weak markets. They’ve done well in bull phases, too. During the five years to the market’s last peak in October 2007, utility stocks rose by 194%, compared with a 139% gain in the MSCI World index, says Bloomberg. Add in dividends, and utility stocks returned 257% over the period – 89% better than the wider index. Among others, we like National Grid (LSE: NG/, 557p), currently yielding 6.9% and trading on a forward p/e of 9.8 or water distributor United Utilities (LSE: UU/, 500.5p) which is on a forward p/e of 9, and yields 6..9% It’s not a traditionally defensive sector, but we still like the oil majors. Analysts seem to agree that their dividends won’t be threatened unless the oil price falls to $30 a barrel or less. With long-term demand for energy only set to rise, we think it’s a good idea to have exposure to the sector via a play such as BP (LSE: BP/, 491p), which yields 7.5% and trades on a forward p/e of 8.2.
Five stocks we like
There are plenty of stocks and sectors we like. This isn’t an exhaustive list, but it does include some of what we believe are the most attractive defensive plays at the moment. The pharmaceuticals sector has fallen out favour with investors over the past decade, and now the prospect of US healthcare reform, which could hit future profits, has been taking its toll on pharma share prices too. Investors fret that “expiring patents will put pressure on billions of dollars of blockbuster drug sales over the next few years”, says the FT’s Lex. “Yet the industry has been in a similar position before”. Drug makers pulled through the 1960s and 1970s “when research productivity plummeted” by creating “a series of new blockbusters and two decades of bumper profits”. What’s more, drug firms are still very good at churning out cash. Over the last year, the world’s top ten drug makers by revenue have produced over $78bn of free cash flow. Today, says Lex, “most big drug groups are well-run businesses with strong cash flows and solid long-term prospects – just the kinds of companies that strategic investors with an eye to the future should like”. That makes UK-listed
“There’s a lot of debt repayment still to do”
en the S&P 500 index by an average of 12% over the past six recessions, according to analysts at Merrill Lynch. So assuming you aren’t put off by the ethical issues around the sector, British American Tobacco (LSE: BATS, 1,766p) looks good. Over the long term, it has easily outshone the overall UK market indices in terms of performance. Yet it’s still a relatively cheap share, despite its ongoing ability to produce strong cash flow. On a forward p/e of 11.2, and a 5.4% 2009 yield, which is set to rise to 5.8% in 2010, the group remains a great value stock with a strong track record. Another sector well known for its defensive qualities is the utility sector. Utilities
applies to individual stocks: total returns from those with above-average dividend yields beat those with below-average In the long run, dividends are the key driver of returns on stocks. Since 1900, yields. In other words, you get better the S&P 500 has returned an average of returns from investing in stocks that are 6% or so a year in real (inflation-adjusted) already good yielders, than from hoping terms, says Capital Economics. But most that stocks that aren’t will grow their yield 1-year time horizon 5-year time horizon of that was down to reinvesting divisubstantially. The good news is that there Dividend yield Growth in real dividends Change in valuations dends. Capital gains on the original are plenty of high-yielding stocks around Jan Feb Mar Apr May Jun Jul investment account for just 1.5% a year. just now. But how sustainable are those dividends? There’s no doubt that in a deep recession dividends The longer you hold your shares, the more important diviwill be cut hard. Many stocks trade at high yields for good readends become. Over one year, around 60% of an investor’s son; their dividends will be annihilated and won’t be reboundreal return comes from changes in the stock price, says James ing soon. Recent examples include most of the banking sector Montier of Société Générale. But over five years, the combinaand the housebuilders. Avoiding traps such as these is really a tion of the initial dividend yield and the growth in dividends macroeconomic judgement: if the outlook for a sector is very accounts for 80% of returns. In short, unless you’re a trader, bleak, then it should be ignored regardless of how tempting the dividends matter a lot. That makes sense. A share is a claim on current yield looks. Beyond this, investors can apply a number a company’s assets and future cash flows. So in the long term, of criteria to stocks to check the sustainability of their dividends. share prices must be driven by how much hard cash the company returns to shareholders. In modern markets, the initial Lapthorne found that at the simplest level, selecting stocks with yield has been very important, says Montier’s colleague Andrew yields between 100-120% of the market average delivered good Lapthorne. From 1970 to the present, dividend growth beat inflaresults (very high-yielders are often distressed). For a more tion by an average of just 1.2 percentage points across the five complex screen, he found that checking the Piotroski score (a biggest equity markets (France, Germany, Japan, Britain and measure of the quality of the firm – see page 10) and balanceAmerica). The bulk (70%) of real returns from dividends came sheet strength (he used a complex test called the Merton from the initial yield. model, but the Altman Z score is a simpler alternative – also on page 10) gave the best results. Yet the commonly used earnings So investors should get the best returns by investing when divicover metric (earnings/dividend, which shows how well covdend yields are high, rather than by betting on growth. This also ered a dividend is by profits) didn’t improve performance.
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
Why dividends matter
Contribution to total real return depends on your time horizon – US data since 1871
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Source: SG Global Strategy Research
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Which sectors will survive the downturn?
by Tim Bennett Which industry sectors are best placed to withstand the recession? Accountancy group PricewaterhouseCoopers (PWC) has taken a look at how vulnerable 15 major British business sectors are to the downturn. The group’s head of macroeconomics, John Hawksworth, looked at three main features: cyclicality, current financial strength and growth potential. So which sectors should stay strong – and which should you avoid?
PWC Sector Vulnerability Index – top and bottom five sectors
Metal products Financial services Hotels, restaurants Engineering Transport, storage Non-food retail Food manufacture Sainsburys Chemicals (RHS) Tesco (LHS) Food retail Utilities
0 10 20 30 40 50
most vulnerable
least vulnerable
with each sector’s average longterm output growth trend over the past 20 years. Overall, British GDP has grown at around 0.65% per quarter over that period, so a number above that is a good start. For the business services sector, for example, it’s over 1%, whereas for oil and gas it’s –0.3%, due in part to dwindling North Sea output.
60 70 Source: PWC
1. Cyclicality
Analysts often describe sectors as either cyclical or defensive (counter-cyclical). Defensive sectors are those that have proved their ability to weather a previous downturn, whereas cyclicals tend to get dragged rapidly into the mire. But what is ‘cyclicality’? PWC splits it into two aspects. First there’s what they call the ‘economic beta’. This is the relative responsiveness of the output of a sector to overall changes in national gross domestic product (or wealth) over the last 20 years. In other words, this measures how tightly a sector is tied to the overall economic cycle. The higher the beta of a sector, the more sensitive it is to a sudden change in economic growth (GDP) and the greater its vulnerability to recession. So, for example, the post and telecoms sector has an economic beta of 2.3, meaning that for every 1% decrease in GDP, this sector sees, on average, a 2.3% drop in output. That sensitivity increases its final ‘vulnerability score’.
you might expect – that they are “less susceptible to the general economic cycle”.
Secondly, the p/e ratio was measured on the basis that, after the recent battering taken by share prices, anything rated above-average must be viewed by analysts as a decent bet.
2. Current financial strength
Hawksworth then reviewed key ratios for over 600 listed British firms, aiming to find which “can generate significant cash from either retained profits or external resources”. These have an edge, as not only are they well placed to ride out a recession, but they may also “be able to improve their market positions through organic growth and picking up assets at bargain prices”. The first of the four indicators used was decent profitability measured as return on capital employed (ROCE) – financial
Lastly, the study reviewed the ratio of exports to total domestic output. The aim was to expose export-intensive sectors. A high score is bad news, says PWC, as in a downturn, “exports tend to be more volatile than domestic demand”.
Winners and losers
Metal products emerged as the worst sector. It is the most vulnerable to the downturn, says the report, due to a combination of high cyclicality and volatility (equity beta 1.6), limited potential for future growth and the lowest level of interest cover of any sector, despite modest gearing levels. Financial services comes a close second, followed by hotels and restaurants. So you should also steer clear of any firm that employs either star bankers or celebrity chefs.
“Steer clear of firms with star bankers or celebrity chefs”
services firms came bottom on this measure. Next, the ability to service existing debt and even raise more was tested using gearing (the ratio of debt to equity funding from the balance sheet) and interest cover (profit before interest as a multiple of one year’s interest expense). Chemicals firms scored well here. Lastly, a high ‘quick’ ratio (current assets as a multiple of current liabilities) helps to show whether a firm has decent shortterm liquidity.
Next, there’s the ‘equity beta’. This focuses on how sensitive the shares within a particular sector are to overall stockmarket movements. A high beta on this measure (anything above one, says PWC) points to greater volatility and a bigger risk that the sector will be disproportionately pummelled as the economy tanks. On this measure, for example, utilities scored 0.8, which suggests – as
3. Growth potential
Here, PWC took three separate measures of long-term growth potential, starting 7
However, PWC likes chemicals, a sector dominated in Britain by big pharma firms. In the short term, they can rely on a “steady flow of orders from the NHS”. We like GlaxoSmithKline (LSE:GSK). Next come food retailers such as Tesco (LSE: TSCO) and utility firms such as National Grid (LSE:NG). As the report concludes, “electricity, gas and water suppliers are more affected by regulatory regimes and weather conditions than short-term economic fluctuations”, making them a relatively safe shelter as the storm rages. First published in March 2009
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How to tell gems from dross
Some stocks are cheap for a reason. Others are just plain cheap. But how to tell which is which? Tim Bennett explains
How can you separate quality stocks from those destined for the scrap heap? And which performance indicators can you trust in a downturn? Two classic tests for a cheap stock are a low price/earnings ratio (p/e) and a high dividend yield. Falling equity markets quickly throw up ‘buys’ on both measures. Take a stock with a share price of 100p, a full-year dividend of 5p per share, and forecast earnings per share for the next year of 10p. The share price is 10 times forecast earnings, so the p/e is 10, while the dividend yield – the annual dividend as a percentage of the share price – is 5% (5p/100p x 100%). But if the share price then collapses to 50p, with earnings and dividends unchanged, the p/e halves to five (50p/10p), while the yield doubles to 10% (5p/50p x 100%). On the strength of those numbers alone, the stock now looks much cheaper in relation to forecast earnings – a low p/e – and also offers a much higher income return. But is it a buy? Not necessarily. The sudden share price falls that push up the yield often reflect doubts about both future earnings and a firm’s ability to make its next dividend payment. So dividend yields well above the return available on far less risky government bonds or cash accounts often turn out to be honey-traps. That’s especially true of firms that suffer from high ‘operational gearing’. it, given that the interest charge is no longer covered (40/50 is just 0.8), even though the firm still generates a positive return on its equity capital of 8% (40/500). Unfair? Perhaps, but cashstrapped banks are targeting everything from housebuilders to hedge funds that lack solvency, for which low interest cover and high gearing are classic tests.
Solvency and liquidity
Even a solvent firm can go bust for lack of liquidity. Imagine you need to borrow £50 in a hurry because you owe it to a mate who wants it back and you don’t have the cash. That’s a liquidity crisis. But if you have a watch worth at least £100 you are technically ‘solvent’ – you have an asset worth at least what you owe. You could solve your liquidity problem by taking it to a pawn-broker and handing it over as collateral in return for say £80 (a broker will always apply a ‘haircut’), £50 of which goes to your mate. Many large, solvent (meaning they carry modest levels of financial gearing) firms have still been faced with liquidity problems. That’s because they find it increasingly hard to repay their creditors as their own suppliers run into cash-flow difficulties and delay payment. And a sudden lack of liquidity can finish any firm. That’s why insolvency group Begbies Traynor has so many retailers on a “critical watch list”.
©BLOOMBERG
You have to look closely to find hidden gems turnover. So, the new profit figure is just £1 (£90 – £80 – £9). That’s a drop of 90%. Businesses with this high fixed-cost structure can be found in every high street.
Gearing – debt invites disaster
Next, we have the other brand of gearing – ‘financial’. Like homeowners, companies can be earning a decent living but still collapse under a heap of debt. Gearing and, better still, interest cover reveal how likely this is. Take a simple
High fixed costs can hurt
Operational gearing explains why weaker airlines, shops and restaurants fold so quickly in a downturn. In short, it’s because their profit margins are very sensitive to even a small dip in sales. That’s down to high fixed costs. Take a business with sales of £100, fixed costs (such as staff and property) of £80 and variable costs (such as light, heat and stock for resale) of £10. Profit is £10 (£100 of sales – £80 of fixed costs – £10 of variable costs). The business is said to be highly operationally geared since fixed costs are a very high chunk (80/90 or 89%) of total costs. Assume sales fall 10% to £90. The fixed costs are just that – fixed. Variable costs, however, usually fall in line with
“A sudden lack of liquidity can finish a company”
company with assets of £1,000. Say it’s funded 50% with debt, costing 10%, and 50% with shareholders’ equity (shares) and makes a profit before interest charges of £80. Gearing – the relationship between debt and equity funding – is 100% (£500/£500). Meanwhile, interest cover – the number of times profit covers the interest charge – is 1.6 times (80/50). Overall the return on shareholder equity is a healthy 16% (80/500). But that low interest cover creates a big risk. Say profits halve to £40. The now-worried bank that provided the original loan could pull 8
Working capital management
So for an investor, evidence of ‘working capital management’ is key. Get it wrong and even a profitable company can face a liquidity crisis. Say a firm makes £800 of cash purchases and £1,000 of cash sales over a month. That’s a profit of £200 at the end of the month and cash in the bank of £200. However, introduce credit terms and the cash (‘liquidity’) position changes. If the same firm, keen to expand, decided to sell 75% of its stock on three months’ credit and agreed similar terms for just 25% of its purchases from suppliers, then under accounting rules the total profit is still £200 (total sales less total purchases). But the company now has a cash overdraft at the end of the first month of £350 (cash received is 25% of £1,000 = £250; while
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cash paid out is 75% of £800, or £600. And £250 – £600 is –£350). Keep that up each month without an agreed overdraft and the company could be put out of business by a trigger-happy lender, even although it is profitable. It’s largely thanks to good working capital management that the likes of Arcadia’s Philip Green and Tesco’s Terry Leahy can fund rapid expansion, even as times get tough for many of their rivals. profits – analysts call this ‘cash cover’. Low cash cover is a classic danger sign that revenue is being booked aggressively and cash not collected. Then check the cash-flow statement for any major spending during the year, especially on long-term or fixed assets. Are these replacements or new assets? If new, where did the finance come from to pay for them? Also look at the stock and receivables lines in the balance sheet – if these are growing faster than sales it may suggest that the company is struggling to shift stock, or is offering more and more generous terms to customers to stay in business – both of which are bad news. At the very least keep an eye on the price to free cash flow ratio (the current share price as a multiple of operating cash flow, minus non-discretionary costs – these usually include interest payments and essential capital expenditure). Be wary of stocks that carry a low p/e ratio but a high P/FCF ratio (a sign the stock is actually expensive, even high risk, when hard cash flow is taken into account). For more on cash flow, see the box below.
Cash flow – avoid naked swimmers
Another crucial thing to remember is that you can’t just rely on profits. Here’s why. Take a car company as an example. If it sells a £10,000 model, then even if it does so on credit - however generous the terms - it gets to book the sale immediately in a profit and loss account. So everything looks fine. But what if the end customer delays payment or even goes bust? Cash flow is much harder to fudge – if a customer pays, a firm records a £10,000 inflow, but until then, it books nothing. So how do you test for strong cash flow? A good start is checking whether a firm
Keep an eye on cash flow has ‘net cash’ (rather than ‘net debt’), so balance-sheet cash should exceed interestbearing debt. Then check the relationship between operating profit (in the profit and loss account) and operating cash flow (from the cash-flow statement). You want cash flow to match, or ideally exceed,
Three questions you must ask about cash flow
There’s more to a safe company than low borrowing or gearing ratios - you have to dig out a firm’s cash-flow statement too. This 12-month summary of a company’s cash inflows and outflows will enable you to answer three key questions. firm needs to spend on new long-term assets to stay in business. The first two can be found on the main cash-flow statement. The last one can’t, but may be approximated by using the annual deprecation charge – an accounting estimate of one year’s wear and tear. Free cash flow should be positive and ideally consistent with past years, allowing for changes in activity. If sales have fallen by, say, 10%, free cash flow will probably have fallen too – but not by 50%. Firms then have a choice about how they apply free cash flow. Tesco has grown rapidly in the past, using its free cash flows to buy new freehold sites. But if a firm has lots of free cash flow yet isn’t expanding or paying it out as a dividend, be concerned. What return is it generating that justifies your continued support? Also crucial to most investors is the relationship between free cash flow and the equity dividend. Be worried if free cash flow doesn’t cover the dividend at least twice, as future payouts might be at risk.
1. Where does the cash come from?
Just as you can supplement a salary by remortgaging or flogging the family silver, a firm can boost short-term cash flow by borrowing, or selling assets. But there are only so many assets you can sell. Without a regular income, a firm will quickly run out of cash. So find the most important number near the top of the cash-flow statement: ‘cash flow from operating activities’. This shows how much cash a firm makes from its core business activity. A negative is a huge red flag. Then check back a few years. Highly volatile operating cash flows can suggest trouble – Enron was a classic example. A firm can also enhance operating cash flows by delaying payments to suppliers, just before the financial year-end. Look at the note that supports the cash-flow figure, in particular the line on ‘change in creditors’. If the number has jumped without a corresponding rise in activity – ‘cost of sales’ – in the profit and loss account, be suspicious. Also, compare the firm’s ‘operating profit’ to operating cash flow. Big variations, or an operating profit not at least matched by a similar amount of operating cash flow, are both warning signs.
3. How is the firm financed?
The final area to look at is the ‘cash flows from financing activities’ section. Just as you shouldn’t extend your mortgage to pay for day-to-day living, so for firms, short-term finance pays for short-term activities (management of customers, trading stock and suppliers, for example) and longterm finance pays for investment. A typical bankruptcy candidate will raise long-term finance as new debt or equity, then use it just to keep trading. So compare the total raised as debt or equity in the ‘cash flows from financing activities’ section and the amount being spent on new assets in the ‘cash flows from investing activities’ above it. A big mismatch with no explanation from directors is another warning sign.
2. Where does all this cash go?
Next, look at where all the operating cash flow goes. First, check the ‘free cash flow’. Take ‘cash flow from operating activities’ and deduct non-discretionary spending, such as interest paid to lenders and banks, tax paid and whatever the
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How Z scores can help you beat the slump
by Tim Bennett Before the credit crunch struck, corporate solvency was the last thing on investors’ minds. Cash was easy to come by and consumers were spending freely. But those days are long gone. And this newly-cautious environment has led to the rehabilitation of out-of-favour investment measures, such as Edward Altman’s Z score. The system was originally devised back in the 1960s to warn investors about firms at risk of going bust. But it can also help you find the sectors and stocks with the strongest balance sheets. In other words, the ones that are best able to withstand the downturn. to its size. Basically, it demonstrates how much value for money a firm is getting from its assets. More efficient companies tend to be better placed to thrive during hard times. In Vodafone’s case, the relevant figures are the operating profit of £10,047m and total long- and short-term assets, which add up to £127,270m. Vodafone this is £35,478m.
5. Market cap to total liabilities
This offers a quick test of how far the company’s assets can decline before the firm becomes technically insolvent – the point at which its liabilities exceed its assets. For Vodafone, the market cap on 4 August 2008, says Digitallook.com, was £72.18bn, while total liabilities (that’s the short and long-term liabilities combined) come to £50,799m. You could calculate all of these ratios and then weight them by hand. But it’s faster to get the relevant figures from the balance sheet and profit and loss, then feed them into an online Z score calculator, such as the one at Creditguru.com/CalcAltZ.shtml. Using the figures from the example above gives Vodafone a Z-score of 0.364.
2. Retained earnings to total assets
This indicates the cumulative profitability of the firm, again compared to its overall size. Shrinking profitability is obviously a warning sign. This measure can also indicate how highly geared a company is. High retained profits suggest that a firm may have financed its assets through profits rather than debt. Vodafone doesn’t have any retained profits; rather it has –£81,980m of retained losses.
How Z scores work
Altman’s model is based on analysing the financial strength of a company using five ratios built on key numbers mainly taken from a firm’s balance sheet, along with a few from the profit and loss account. Each ratio is then weighted to reflect its relative importance before the five are added together to generate a Z score, usually a single digit figure. Here’s how it works. We’ve used figures drawn from the income statement and balance sheet from the 2008 accounts of FTSE 100 firm Vodafone, purely for illustrative purposes. The ratios are listed in order of importance.
What does it all mean? 3. Working capital to total assets
This compares liquid assets, called “working capital” or “net current assets”, to the total long (“fixed”) and short-term (“current”) assets from the balance sheet. A firm in trouble will usually experience shrinking liquidity by this measure. In other words, as sales fall or costs rise, the amount of easily available cash will fall. Vodafone’s balance sheet at 31 March 2008 shows current assets of £8,724m, minus current liabilities of £21,973m, giving working capital of –£13,249m. In this case, you’d want to avoid Vodafone (though bear in mind these are the 2008 figures). The weaker the Altman score, in particular a reading around or below about 1.6, the greater the chance of a firm suffering financial distress within the next two years. While no one is suggesting Vodafone is about to go bust, Graham Secker of Morgan Stanley points out that firms with a Z score of below one have always tended to underperform the market, “particularly in recessionary periods”. Taking the period from 1990 to 2007, the average compound annual growth rate (CAGR) for these stocks was –3.3% against 4.1% for the median stock in the market. On the other hand, stocks scoring between 2.5 and 3 on the Z score provided a CAGR of 6.3%.
1. EBIT to total assets
This is the most heavily weighted – in other words, the most important – component of the Z score. EBIT is earnings before interest and tax, or “operating profit”. This ratio shows how productive a company is in earnings terms, relative
4. Sales to total assets
This is a measure of how effectively the firm uses its assets to generate sales. This uses the turnover figure at the top of the profit and loss statement – for
Piotroski score: what makes a good balance sheet?
There are many ways to stress test a balance sheet, which is “the first hurdle to overcome for any investments before value or growth considerations are taken into account” says Teun , Draaisma of Morgan Stanley. One of the most comprehensive and better-known is the Piotroski score. Devised by a University of Chicago accounting professor, it's a simple nine-step method that rates a stock primarily using balance-sheet criteria, backed up with decent cash flow and earnings strength. The score for each test is either one if a firm passes, or zero if it fails. Combine all nine and you get a total score between zero and nine. The nine Piotroski hurdles are as follows (score one for “yes” and zero for “no”): positive net income; positive cash flow; operating cash flow above net income; a lower ratio of debt to total assets than the previous year; increased working capital (or “net current assets” on a balance sheet); higher asset turnover (sales/total assets indicates productivity); higher return on assets than the previous year; the same or fewer shares outstanding than a year ago; and, finally, rising profit margins. Stocks with a score of five or more have financial strength.
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