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By: Tim Bennett
03.04.2020
03.04.2020
Background
How quickly times change. A few weeks ago, stock markets were roaring to new highs. Now, according to many commentators, we are staring a recession in the face. The key question for investors is what will mark out a strong stock from a weak one.
The ideal company
So, let’s start with the characteristics of a firm that is likely to weather this tricky economic environment and even do relatively well. I think there are three;
Let’s take a quick look at each of these in turn.
The importance of product
Rarely can what a firm makes and sells have mattered more, as supply chains get disrupted and consumers rein in spending as they adapt to normal life under new restrictions. In summary, investors need to take a close look at what a firm does and how it does it in terms of business continuity.
The “stickier” a product and the more vital it is to everyday living the better a firm will do. This doesn’t just mean investors are limited to firms involved in food and power production – home entertainment and technology in general will be receiving a huge boost from the “new normal” that is life under a coronavirus lock down.
Gearing isn’t good
The next problem some firms will face is being overleveraged. This comes in two forms, financial and operating. Financial leverage is a high level of debt finance to equity – for now, with interest rates at record lows, this is less of a headache but nonetheless something to keep an eye on should we see inflation rear it head in the future.
No, the key form of leverage to watch now is operational gearing. This grand-sounding term describes the relationship between a firm’s fixed and variable costs.
The reason this matters is that a firm with high fixed costs (perhaps permanent staff and property) will struggle to maintain profitability as revenues fall. I illustrate this here;
What this example shows is that a 10% fall in revenue could trigger a 90% fall in profits for a firm with high fixed costs. Banks, airlines and hotels all have just such a cost structure.
Cash matters
The third factor that will separate survivors from laggards is cash flow.
And the key to decent cash flow is working capital management. This is a firm’s ability to collect cash from customers and manage payments to suppliers as the next example shows;
Conclusion
So, in summary, if a firm offers the right products (and can deliver them), has relatively low levels of operational gearing and keeps tabs on working capital, it has a chance to not just survive but also take advantage of the commercial opportunities that this sort of environment will throw out.
To find out more
Please speak to an Adviser to discuss your investments, or email me on [email protected] if you have specific queries relating to the video that accompanies this script.
