The Best Recession Stocks

8/2/2019 The Best Recession Stocks

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These are uncer-tain times. Theworst of thefinancial crisishas passed fornow. But no oneknows for surewhat to expectnext. A few are

predicting astorming recovery. But its hard to seehow that can happen, with the bankingsystem still dangerously fragile andunemployment yet to peak.

A bigger and even more uncertainquestion is whether well face defla-tion, inflation or perhaps even hyperin-flation. On the one hand, the collapsein asset prices and the near-bankruptcyof much of the Western banking systemmeans that credit will be squeezed for along time to come. Combined with a

growing number of jobless, that pointsto Japan-style deflation.

On the other hand, the worlds centralbanks in Britain and the US in particu-lar are pumping out money like theresno tomorrow. They seemingly want toavoid deflation at any cost. But whathappens if they succeed? Then inflationcould start to take off. If they are tooslow to pull out the vast sums of moneytheyve pumped into the system, theninflation could get out of control, leadingultimately to a catastrophic currency col-lapse.

Those are two very different outcomes.And for all we know, we could see bothat various points along the cycle. Indeed,the only thing that it feels safe to saywith any conviction is that well be fac-ing uncertainty for a long time to come.

And that means one thing for investors

play it safe. Now, normally safety wouldmean developed government debt giltsin the UK, Treasuries in the US. Buttheres a problem here. As we notedalready, western governments are hugelyindebted due to their policies of printingas much money as possible to lessen theimpact of the recession.

But theres only so much money-printingthat a country can do before its creditors

start to worry about how it will paythem back. That would lead to a hugesell-off in government debt, driving

yields higher (yields rise as prices fall).

The US might be able to get away withrunning a massive deficit for a time, atleast. But Britain is by no means certainto get away with it. Already, some of theworlds biggest bond investors includ-ing US investment management giantPimco, which runs the worlds biggestbond fund are voicing concerns aboutUK gilts. One fund manager at Britishinvestment group Standard Life hasdescribed buying UK government debt aslike playing Russian roulette.

So what should you buy? We think thebest bet is to find solid companies. In thelong run, a well-run company shouldgrow alongside the economy. And in thehard 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 whileyou wait for the economy to recover.

These stocks are usually known asdefensives. Thats because they dontdepend as much on economic growth tokeep selling their products companiessuch as pharmaceutical firms, utilitiesand consumer goods firms, for example.These are the opposite to cyclicals,which suffer a great deal when economicgrowth falls stocks such as airlines,

certain types of retailer, and mininggroups.

The good news is that its preciselythese defensive stocks that look cheapright now. The rally from the stockmarkets March lows has almostentirely favoured cyclicals, as investorspiled in, in the hope of a recovery. Butwith many disappointments still tocome in the economy, we reckon this is

somewhat premature. So we suspect thatanyone buying defensives now canexpect them to rebound as investors

switch back into safe havens.

In this report, we look at some stocksthat we like on this front. But more thanthat, well equip you with the tools youneed for your own investment analysis,so that you know what to look for whentrying to decide whether a share is worthadding to your portfolio.

Good luck with your investments!

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A MONEYWEEK SPECIAL INVESTMENT REPORTA MONEYWEEK SPECIAL INVESTMENT REPORT

Protect your portfolio

from the slump

The worst of the finan-cial crisis may have

passed for now - butwhat happens next?

John Stepekemail: [email protected]

3 Five defensive tipsNews of a recovery has been

somewhat exaggerated - so

here are some of the stocks

you should be buying now.

8 Pick survivors Not allstock market value indicators

work well when hard times

hit. Here are the ones you

should really be focusing on.

9 Cash flow The three keyquestions you should be

asking about how a company

gets its cash and what it

does with it.

10 Two scores that canbeat the slump Two old-fashioned measures that are

making a comeback now that

balance sheets matter again.

In this report


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It looks like the worst of the

gloom is blowing over

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 dailydiet of grim headlines and tales of horrorabout the financial crisis, anyone who hasso far avoided losing their job might nowbe wondering what all the fuss was about.After all, its just a recession. Its notWorld War Three; its not the BlackDeath. Comparisons with the GreatDepression are by no means an exaggera-tion in terms of raw economic data. Butthe images conjured up by that era oferstwhile Masters of the Universe reducedto selling apples on street corners, andfamilies trying to eke out a living in the

dustbowl suggest a desperation thatmost people in the West simply dont feel,thanks to modern innovations such as thewelfare state.

As Lucy Kellaway put it in the FinancialTimes recently: the human spirit doesnot find it agreeable to stay down for toolong. Having accepted that were inrecession, people are now deciding itsreally not that bad. Combine that withsigns that the rate of collapse in the globaleconomy is easing off, and its small won-der many have been tempted to throw offtheir tin hats and celebrate a new dawn.Goaded partly by the utter lack of interestavailable on most savings accounts,investors are piling back into the stock-market. Some are even looking at gettingback into the property market.

So should you join them?

The state were inThere are undoubtedly some signs ofimprovement in parts of the financial sys-tem. Credit conditions have relaxed some-

what, with various key lending rates nowback to levels not seen since before thecollapse of Lehman Brothers rocked themarkets.

Meanwhile, manufacturers have slashed

production rapidly in reaction to globaldemand falling off a cliff, so a boost froman element of restocking as people buythings they now need to replace seemslikely in the coming year.

But this crash happened so hard and fastthat a fall in the rate of decline had tohappen eventually. As Robin Aspinall ofHalkin Services says, if something cantget any worse, it must get better. Moreto the point, in the FTs words, signs ofcredit-market stress remain at high lev-els. As for consumer spending, withunemployment still high and rising, itshard to see where consumers will find themoney to support big increases in spend-

ing.

So is the worst behind us? In a word.No, as the FTs Martin Wolf put it backin April. As Wolf notes, weve barelystarted dealing with the problems that led

to the crash in the first place. In America,for example, total private-sector debtrose from 112% of GDP in 1976 to295% at the end of 2008. Financial sectordebt alone jumped from 16% to 121% ofGDP over this period. Yet during 2008,leverage rose still further. So thereremains a lot of saving and debt repay-ment to be done.

Here in Britain, the pictures just as weak.Lending growth is continuing to slow. Arecord of nearly 30,000 people in Englandand Wales went bankrupt in the first threemonths of this year, up 19% on the yearbefore. And nearly 5,000 firms went bustduring the same period, up by more than

50%.

As Alan Tomlinson of insolvency practi-tioner Tomlinsons says, these statisticsfirmly squash the notion that there areany green shoots of recovery out there.

but appearances can bedeceptive. How can you tell ifa break in the clouds is thestart of summer? JohnStepek explains.

Look out below - there could be some nasty surprises still in store


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Since last autumn many of the compa-nies we are seeing have suffered signifi-cant drops in turnover theyve beenunable to replace. And as

James Ferguson points out in the boxbelow, the banking crisis is still unfold-ing, so we can expect banks to contin-

ue keeping a tight rein on lending toboth businesses and consumers.

Governments are also becomingincreasingly entrenched in their coun-tries economic and financial systems.There are the waves of money beingprinted by central banks, while interestrates are abnormally low across theworld. Meanwhile, from China to theUS and Britain, the state is directinglending policies and deciding whichfirms (banks and car makers) are

spared, and which go to the wall (retailersand small businesses).

But as the influence of the public sectorexpands, so the private sector whichultimately drives growth is squeezedout. As Tim Price of PFP WealthManagement notes, whether businessessurvive or fail during this recession will bea function not of the market, but ofwhether government wants them to.That is not an economy that most entre-preneurs will want to play much part in,and it throws the bear-market rally into a

sharp and uncomfortable focus.

Reversing this position will take a long

time, and wont be easy. As Wolf sumsup: The brutal truth is that the financialsystem is still far from healthy, thedeleveraging of the private sectors ofhighly indebted countries has not begun,the needed rebalancing of global demandhas barely even started, and, for all thesereasons, a return to sustained, private-sec-tor-led growth probably remains a longway in the future.

What about stocks?But a weak economy need not mean adeclining stockmarket. Indeed, the

green shoots are much more prevalent inthe market than in the economy, saysEdward Hadas on Breakingviews. But

before you pile in, be warned thereare plenty of reasons to suspect that thisisnt a new bull market. For a start, itsnot unusual to have strong rallies with-in a wider bear market. As AlbertEdwards of Socit Gnrale points out,the current pop is not dissimilar to

the many bear market rallies between1929-1933, where hints of recoveryled to strong 25%+ rallies... this opti-mism was subsequently crushed.

For another thing, in the first instance,the bounce was led by the same stocksthat led the crash financials in partic-ular and also resource stocks. Peopleare still acting on the basis that thesestocks have fallen so far that theymust be cheap by now the sameattitude that bit investors during the

post-tech-bubble collapse. DavidRosenberg of Merrill Lynch points outthat you know its a low-quality rallywhen the top 50 most heavily shortedstocks are the ones that outperform themost.

We also havent seen many of the signsthat usually precede a new bull market.Simon Thompson in Investors Chroniclepoints to Russell Napiers study of majorUS market bottoms, Anatomy of theBear. This found that at the end of abear market there tends to be a final

slump in share prices on low trading vol-umes (as investor selling becomes com-pletely exhausted) and confirmation of

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 can-

celled. 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 arent wor-

ried about what this recession looks like right now. Were look-

ing at what has happened in the past when you have a bank-

ing crisis. And the first conclusion that positively leaps out at

you is: this banking crisis, at least in terms of how it will affectthe average person in the street, hasnt 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 relat-

ing to bad loans. Of course, we cant know if the banks capital

is going to get wiped out this time until after weve seen what

default and, more importantly, recovery rates are like. But we

can have a go at working it out using past banking-crisis reces-

sions.

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 worlds

banks.The report finds that, retained earnings aside, and work-ing on loan loss assumptions garnered from previous reces-

sions, the Western worlds banking systems will have eroded

their capital bases to near zero by the end of next year.

Continued on page 5

Waves of money are being printed by central banks

BLOOMBERG


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the bull market is then sig-nalled by rising prices onexpanding volumes. But vol-umes have been modest dur-ing the current rally. So theshort-term indicators arentgood.

Stocks face plenty of headwindsin the longer run too. Investorsare going to have to absorb alot more shares. Just as firmsswapped equity for cheaperdebt during the boom years,that process will reverse asfirms, locked out by high debt-raising costs, need to raisemoney through rights issuesinstead. As John Waples notes in TheSunday Times: We still have dozens of

fund-raisings to come, and billions ofpounds that need to be refinanced infinancial markets where the supply ofnew capital is thin on the ground.

The governments presence in the marketswill also have an impact. As the invisibleprivate hand of Adam Smith begins toresemble more and more the public fist ofgovernment, says Bill Gross of bondfund manager Pimco, then asset valuesshould be negatively affected.

As an example, he points out that if

FedEx deserves a p/e of 12, wouldnt thevalue of the [state-owned] US Post Officebe substantially less?

What should you do now?For many investors, this is the most dan-

gerous period. Theyve already seen theirnet wealth hammered by the originalcrash. When the rally starts, they ignoreit. But as it continues and stocks climbsteadily higher, it becomes harder towatch those gains being made withouttaking part. Investors whove alreadybeen burnt by the original crash are par-ticularly vulnerable they start to hopethat by taking part in one big rally theycould make back some of their losses. Sothey pile in, usually just as the rally iscoming to an end and they get wipedout again.

The good news is that you dont have tostay out of the market. You just have to

do what smart investorsalways do: buy solid assets atgood value prices. On thatscore, there are still opportuni-ties out there.

As James Ferguson points out

in the box on page 4, duringJapans slump, governmentbonds did well because ofdemand from banks. Wewould be less keen to buy giltsright now, simply because ofthe level of uncertainty overwhat the government andBank of England might donext. However, there are otherlessons we can learn from

Japans experience.

Andrew Lapthorne of Socit Gnralepoints out that buying stocks with highdividend yields and solid balance sheetsproduced strong returns. In particular, asDavid Stevenson highlights in InvestorsChronicle, picking stocks with a lowprice-to-book ratio versus their historyproved to be a winning strategy.

More to the point, these are the sorts ofstocks that have been underperfoming inthe rally so far. So on the one hand theystill look cheap, and on the other, if therally continues, then theyll get lifted

along with the rest of the market. AsGraham Secker at Morgan Stanley notes,there are good absolute valuations on

This rather shocking conclusion is the reason

the IMF believes Western governments still

have to inject huge sums into their banks. Its

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,

those that might default, as opposed to risk-

free loans that cant default, otherwise known as gilts. So what

banks do once a crisis has hit is de-risk the profile of their bal-

ance sheets by replacing risky loans to the likes of you and me

with risk-free assets in the form of gilts. So claims on govern-

ment are set to rise sharply, while a matching drop in claims on

the private sector will keep the credit crunch alive and well for

some years to come as banks continue to reduce lending.

ProfessorTim Congdon charts many examples of this process

at work during the balance-sheet rebuilding phase of bank

crises. In Japan, once the government injected capital into the

banks and they started aggressively address-

ing 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 govern-

ment 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.

These multi-year balance-sheet restructurings of the banks are

why banking-crisis recessions are more serious than normal

recessions.The conclusion must be that the credit crunch that

beset the financial markets in 2007-2008 will turn into a multi-

year credit crunch on the high street from 2009 onwards.

The reason this recession hasnt yet hit the households ofthose school children I was talking to is not because they have

been lucky, nor because the severity of this crisis has been

overblown in the press. No, its mainly because, as far as the

person on the street is concerned, it hasnt even begun yet.

The feel-good recession

If this is a recession, whydoes it feel so good?Continued from page 4

Beware bear market ralliesBLOOMBERG


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offer not to mention solid dividendpayments.

Five stocks we likeThere are plenty of stocks and sectors welike. This isnt an exhaustive list, but itdoes include some of what we believe are

the most attractive defensive plays at themoment. The pharmaceuticals sector hasfallen out favour with investors over thepast decade, and now the prospect of UShealthcare reform, which could hit futureprofits, has been taking its toll on pharmashare prices too.

Investors fret that expiring patents willput pressure on billions of dollars ofblockbuster drug sales over the next fewyears, says the FTs Lex. Yet the indus-try has been in a similar position before.

Drug makers pulled through the 1960sand 1970s when research productivityplummeted by creating a series of newblockbusters and two decades of bumperprofits. Whats more, drug firms are stillvery good at churning out cash. Over thelast year, the worlds top ten drug makersby revenue have produced over $78bn offree cash flow. Today, says Lex, most bigdrug groups are well-run businesses withstrong cash flows and solid long-termprospects just the kinds of companiesthat strategic investors with an eye to thefuture should like. That makes UK-listed

pharma giant GlaxoSmithKline (LSE:GSK, 1,120p), yielding 5.4%, and on aforward p/e of 9.4, look like a good play.

Theres also a strong defensive case forholding something completely different tobacco stocks. So-called vice stocks,

which include tobacco and gambling,have a good track record of performingduring recessions. In fact, they have beat-

en the S&P 500 index by an average of12% over the past six recessions, accord-ing to analysts at Merrill Lynch. Soassuming you arent put off by the ethical

issues around the sector, British AmericanTobacco (LSE: BATS, 1,766p) looks good.Over the long term, it has easily outshonethe overall UK market indices in terms ofperformance. Yet its still a relativelycheap share, despite its ongoing ability toproduce strong cash flow. On a forwardp/e of 11.2, and a 5.4% 2009 yield,which is set to rise to 5.8% in 2010, thegroup remains a great value stock with astrong track record.

Another sector well known for its defen-sive qualities is the utility sector. Utilities

dont depend heavily on economic growthfor their profits people still need energyand water, even in a downturn. The aver-age utility has also hiked its dividends pershare every year since 2001. Thats longerthan any other industry group, excepthealthcare companies. Better yet, judging

by past experience, utilities arent just asafe haven in weak markets. Theyvedone well in bull phases, too. During thefive years to the markets last peak inOctober 2007, utility stocks rose by194%, compared with a 139% gain inthe MSCI World index, says Bloomberg.Add in dividends, and utility stocksreturned 257% over the period 89%better than the wider index. Among oth-ers, we like National Grid (LSE: NG/,557p), currently yielding 6.9% and trad-ing on a forward p/e of 9.8 or water dis-

tributor United Utilities (LSE: UU/,500.5p) which is on a forward p/e of 9,and yields 6..9%

Its not a traditionally defensive sector,but we still like the oil majors. Analystsseem to agree that their dividends wontbe threatened unless the oil price falls to$30 a barrel or less. With long-termdemand for energy only set to rise, wethink its a good idea to have exposure tothe sector via a play such as BP (LSE: BP/,491p), which yields 7.5% and trades on aforward p/e of 8.2.

Theres a lot of debtrepayment still to do

In the long run, dividends are the key

driver of returns on stocks. Since 1900,

the S&P 500 has returned an average of

6% or so a year in real (inflation-adjusted)

terms, says Capital Economics. But most

of that was down to reinvesting divi-

dends. Capital gains on the original

investment account for just 1.5% a year.

The longer you hold your shares, the more important divi-

dends become. Over one year, around 60% of an investors

real return comes from changes in the stock price, says James

Montier of Socit Gnrale. But over five years, the combina-

tion of the initial dividend yield and the growth in dividends

accounts for 80% of returns. In short, unless youre a trader,

dividends matter a lot. That makes sense. A share is a claim on

a companys assets and future cash flows. So in the long term,

share prices must be driven by how much hard cash the com-

pany returns to shareholders. In modern markets, the initial

yield has been very important, says Montiers colleague Andrew

Lapthorne. From 1970 to the present, dividend growth beat infla-

tion by an average of just 1.2 percentage points across the five

biggest equity markets (France, Germany, Japan, Britain andAmerica).The bulk (70%) of real returns from dividends came

from the initial yield.

So investors should get the best returns by investing when divi-

dend yields are high, rather than by betting on growth.This also

applies to individual stocks: total returns

from those with above-average dividend

yields beat those with below-average

yields. In other words, you get better

returns from investing in stocks that are

already good yielders, than from hoping

that stocks that arent will grow their yield

substantially.The good news is that there

are plenty of high-yielding stocks around

just now. But how sustainable are those

dividends? Theres no doubt that in a deep recession dividends

will be cut hard. Many stocks trade at high yields for good rea-

son; their dividends will be annihilated and wont be rebound-

ing soon. Recent examples include most of the banking sector

and the housebuilders. Avoiding traps such as these is really a

macroeconomic judgement: if the outlook for a sector is very

bleak, then it should be ignored regardless of how tempting the

current yield looks. Beyond this, investors can apply a number

of criteria to stocks to check the sustainability of their dividends.

Lapthorne found that at the simplest level, selecting stocks with

yields between 100-120% of the market average delivered good

results (very high-yielders are often distressed). For a more

complex screen, he found that checking the Piotroski score (a

measure of the quality of the firm see page 10) and balance-sheet strength (he used a complex test called the Merton

model, but the Altman Z score is a simpler alternative also on

page 10) gave the best results.Yet the commonly used earnings

cover metric (earnings/dividend, which shows how well cov-

ered a dividend is by profits) didnt improve performance.

Jan Feb Mar Apr May Jun Jul

Contributionto total realreturndependson yourtimehorizonUS datasince1871

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

Dividendyield Growthinrealdividends Changeinvaluations

1-yeartimehorizon 5-yeartimehorizon

Source:SGGlobalStrategyResearch

Why dividends matter


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Which industry sectors arebest placed to withstand therecession? Accountancy groupPricewaterhouseCoopers (PWC)has taken a look at how vulnera-ble 15 major British business sec-tors are to the downturn. Thegroups head of macroeconomics,

John Hawksworth, looked atthree main features: cyclicality,current financial strength andgrowth potential. So which sec-tors should stay strong andwhich should you avoid?

1. CyclicalityAnalysts often describe sectors as eithercyclical or defensive (counter-cyclical).Defensive sectors are those that haveproved their ability to weather a previ-ous downturn, whereas cyclicals tend toget dragged rapidly into the mire. But

what is cyclicality?

PWC splits it into two aspects. Firsttheres what they call the economicbeta. This is the relative responsivenessof the output of a sector to overallchanges in national gross domestic prod-uct (or wealth) over the last 20 years. Inother words, this measures how tightly asector is tied to the overall economiccycle.

The higher the beta of a sector, themore sensitive it is to a suddenchange in economic growth (GDP)and the greater its vulnerability torecession. So, for example, thepost and telecoms sector has aneconomic beta of 2.3, meaning that forevery 1% decrease in GDP, this sectorsees, on average, a 2.3% drop in output.That sensitivity increases its final vul-nerability score.

Next, theres the equity beta. Thisfocuses on how sensitive the shares with-in a particular sector are to overall

stockmarket movements. A high beta onthis measure (anything above one, saysPWC) points to greater volatility and abigger risk that the sector will be dispro-portionately pummelled as the economytanks. On this measure, for example,utilities scored 0.8, which suggests as

by Tim Bennett

you might expect that they are lesssusceptible to the general economiccycle.

2. Current financial strengthHawksworth then reviewed key ratiosfor over 600 listed British firms, aiming

to find which can generate significantcash from either retained profits orexternal resources. These have an edge,as not only are they well placed to rideout a recession, but they may also beable to improve their market positionsthrough organic growth and picking upassets at bargain prices.

The first of the four indicators used wasdecent profitability measured as returnon capital employed (ROCE) financial

services firms came bottom on this meas-ure. Next, the ability to service existingdebt and even raise more was testedusing gearing (the ratio of debt to equityfunding from the balance sheet) andinterest cover (profit before interest as amultiple of one years interest expense).Chemicals firms scored well here. Lastly,a high quick ratio (current assets as a

multiple of current liabilities) helps toshow whether a firm has decent short-term liquidity.

3. Growth potentialHere, PWC took three separate measuresof long-term growth potential, starting

with each sectors average long-term output growth trend overthe past 20 years. Overall,British GDP has grown ataround 0.65% per quarter overthat period, so a number abovethat is a good start. For thebusiness services sector, forexample, its over 1%, whereasfor oil and gas its 0.3%, due in

part to dwindling North Seaoutput.

Secondly, the p/e ratio wasmeasured on the basis that, afterthe recent battering taken byshare prices, anything rated

above-average must be viewed by ana-lysts as a decent bet.

Lastly, the study reviewed the ratio ofexports to total domestic output. Theaim was to expose export-intensive sec-tors. A high score is bad news, says

PWC, as in a downturn, exports tend tobe more volatile than domestic demand.

Winners and losersMetal products emerged as the worst sec-tor. It is the most vulnerable to the down-turn, says the report, due to a combina-tion of high cyclicality and volatility(equity beta 1.6), limited potential forfuture growth and the lowest level ofinterest cover of any sector, despite mod-est gearing levels. Financial services comes

a close second, followed by hotelsand restaurants. So you shouldalso steer clear of any firm thatemploys either star bankers orcelebrity chefs.

However, PWC likes chemicals, a sectordominated in Britain by big pharmafirms. In the short term, they can rely ona 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 asNational Grid (LSE:NG). As the reportconcludes, electricity, gas and water

suppliers are more affected by regulatoryregimes and weather conditions thanshort-term economic fluctuations, mak-ing them a relatively safe shelter as thestorm rages.

First published in March 2009

Steer clear of firms with starbankers or celebrity chefs

Sainsburys (RHS)

Tesco (LHS)

PWC SectorVulnerability Index top and bottom five sectors

MetalproductsFinancial servicesHotels, restaurantsEngineering

Transport,storageNon-foodretailFoodmanufactureChemicalsFoodretailUtilities

0 10 20 30 40 50 60 70

Source: PWC

mostvulnerable

leastvulnerable

Which sectors will

survive the downturn?


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How to tell gems from dross

How can you separate quality stocksfrom those destined for the scrap heap?And which performance indicators canyou trust in a downturn? Two classictests for a cheap stock are a lowprice/earnings ratio (p/e) and a high divi-dend yield. Falling equity markets quick-ly 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 nextyear of 10p. The share price is 10 timesforecast earnings, so the p/e is 10, whilethe dividend yield the annual dividendas a percentage of the share price is5% (5p/100p x 100%). But if the shareprice then collapses to 50p, with earn-ings and dividends unchanged, the p/ehalves to five (50p/10p), while the yielddoubles to 10% (5p/50p x 100%).

On the strength of those numbers alone,the stock now looks much cheaper inrelation to forecast earnings a low p/e

and also offers a much higher incomereturn. But is it a buy? Not necessarily.The sudden share price falls that pushup the yield often reflect doubts aboutboth future earnings and a firms abilityto make its next dividend payment. Sodividend yields well above the returnavailable on far less risky governmentbonds or cash accounts often turn out tobe honey-traps. Thats especially true offirms that suffer from high operationalgearing.

High fixed costs can hurtOperational gearing explainswhy weaker airlines, shops andrestaurants fold so quickly in adownturn. In short, its because theirprofit margins are very sensitive to evena small dip in sales. Thats down to highfixed costs. Take a business with sales of100, fixed costs (such as staff and prop-erty) of 80 and variable costs (such aslight, heat and stock for resale) of 10.Profit is 10 (100 of sales 80 offixed costs 10 of variable costs). Thebusiness is said to be highly operational-

ly geared since fixed costs are a very highchunk (80/90 or 89%) of total costs.

Assume sales fall 10% to 90. The fixedcosts are just that fixed. Variable costs,however, usually fall in line with

turnover. So, the new profit figure is just1 (90 80 9). Thats a drop of

90%. Businesses with this high fixed-coststructure can be found in every highstreet.

Gearing debt invites disasterNext, we have the other brand of gear-ing financial. Like homeowners, com-panies can be earning a decent living butstill collapse under a heap of debt.Gearing and, better still, interest coverreveal how likely this is. Take a simple

company with assets of 1,000. Say itsfunded 50% with debt, costing 10%,and 50% with shareholders equity(shares) and makes a profit before inter-est charges of 80. Gearing the rela-tionship between debt and equity fund-ing is 100% (500/500). Meanwhile,interest cover the number of timesprofit covers the interest charge is 1.6times (80/50).

Overall the return on shareholder equityis a healthy 16% (80/500). But that lowinterest cover creates a big risk. Say prof-its halve to 40. The now-worried bankthat provided the original loan could pull

it, given that the interest charge is nolonger covered (40/50 is just 0.8), eventhough the firm still generates a positivereturn on its equity capital of 8%(40/500). Unfair? Perhaps, but cash-strapped banks are targeting everythingfrom housebuilders to hedge funds thatlack solvency, for which low interestcover and high gearing are classic tests.

Solvency and liquidityEven a solvent firm can go bust for lackof liquidity. Imagine you need to borrow50 in a hurry because you owe it to amate who wants it back and you donthave the cash. Thats a liquidity crisis. Butif you have a watch worth at least 100you are technically solvent you have anasset worth at least what you owe. Youcould solve your liquidity problem by tak-ing it to a pawn-broker and handing itover as collateral in return for say 80 (abroker will always apply a haircut), 50of which goes to your mate.

Many large, solvent (meaning they carrymodest levels of financial gearing) firmshave still been faced with liquidity prob-lems. Thats because they find it increas-ingly hard to repay their creditors as theirown suppliers run into cash-flow difficul-ties and delay payment. And a sudden lackof liquidity can finish any firm. Thats whyinsolvency group Begbies Traynor has somany retailers on a critical watch list.

Working capital managementSo for an investor, evidence of work-ing capital management is key. Get itwrong and even a profitable compa-ny can face a liquidity crisis. Say a

firm makes 800 of cash purchases and1,000 of cash sales over a month. Thatsa profit of 200 at the end of the monthand cash in the bank of 200.

However, introduce credit terms and thecash (liquidity) position changes. If thesame firm, keen to expand, decided to sell75% of its stock on three months creditand agreed similar terms for just 25% of

its purchases from suppliers, then underaccounting rules the total profit is still200 (total sales less total purchases). Butthe company now has a cash overdraft atthe end of the first month of 350 (cashreceived is 25% of 1,000 = 250; while

Some stocks are cheap for a reason. Others are just plain cheap. But how to tell whichis which? Tim Bennett explains

You have to look closely to find hidden gems

A sudden lack of liquiditycan finish a company

BLOOMBERG


9/109


cash paid out is 75% of 800, or 600.And 250 600 is 350).

Keep that up each month without anagreed overdraft and the company couldbe put out of business by a trigger-happylender, even although it is profitable. Its

largely thanks to good working capitalmanagement that the likes of ArcadiasPhilip Green and Tescos Terry Leahy canfund rapid expansion, even as times gettough for many of their rivals.

Cash flow avoid naked swimmersAnother crucial thing to remember is thatyou cant just rely on profits. Heres why.Take a car company as an example. If itsells a 10,000 model, then even if it doesso on credit - however generous the terms- it gets to book the sale immediately in a

profit and loss account. So everythinglooks fine. But what if the end customerdelays payment or even goes bust? Cashflow is much harder to fudge if a cus-tomer pays, a firm records a 10,000inflow, but until then, it books nothing.So how do you test for strong cash flow?

A good start is checking whether a firm

has net cash (rather than net debt), sobalance-sheet cash should exceed interest-bearing debt. Then check the relationshipbetween operating profit (in the profitand loss account) and operating cash flow(from the cash-flow statement). You wantcash flow to match, or ideally exceed,

profits analysts call this cash cover.Low cash cover is a classic danger signthat revenue is being booked aggressivelyand cash not collected.

Then check the cash-flow statement forany major spending during the year, espe-

cially on long-term or fixed assets. Arethese replacements or new assets? If new,where did the finance come from to payfor them? Also look at the stock andreceivables lines in the balance sheet ifthese are growing faster than sales it maysuggest that the company is struggling toshift stock, or is offering more and moregenerous terms to customers to stay inbusiness both of which are bad news.

At the very least keep an eye on the priceto free cash flow ratio (the current share

price as a multiple of operating cash flow,minus non-discretionary costs these usu-ally include interest payments and essen-tial capital expenditure). Be wary ofstocks that carry a low p/e ratio but ahigh P/FCF ratio (a sign the stock is actu-ally expensive, even high risk, when hardcash flow is taken into account). Formore on cash flow, see the box below.

Keep an eye on cash flow

Theres more to a safe company than low borrowing or gear-

ing ratios - you have to dig out a firms cash-flow statement

too. This 12-month summary of a companys cash inflows and

outflows will enable you to answer three key questions.

1. Where does the cash come from?Just as you can supplement a salary by remortgaging or flog-

ging 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 particu-

lar 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

firms 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.

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

firm needs to spend on new long-term assets to stay in busi-

ness.The first two can be found on the main cash-flow state-

ment.The last one cant, but may be approximated by using

the annual deprecation charge an accounting estimate of

one years wear and tear.

Free cash flow should be positive and ideally consistent with

past years, allowing for changes in activity. If sales have fall-

en 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 isnt 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 doesnt cover

the dividend at least twice, as future payouts might be at risk.

3. How is the firm financed?The final area to look at is the cash flows from financing

activities section. Just as you shouldnt extend your mort-

gage to pay for day-to-day living, so for firms, short-term

finance pays for short-term activities (management of cus-

tomers, trading stock and suppliers, for example) and long-

term finance pays for investment. A typical bankruptcy candi-

date will raise long-term finance as new debt or equity, thenuse 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.

Three questions you must ask about cash flow


10/10

How Z scores can help you

beat the slump

A MONEYWEEK SPECIAL INVESTMENT REPORT

Before the credit crunch struck, corporatesolvency was the last thing on investorsminds. Cash was easy to come by andconsumers were spending freely. Butthose days are long gone. And thisnewly-cautious environment has led tothe rehabilitation of out-of-favour invest-ment measures, such as Edward AltmansZ score.

The system was originally devised backin the 1960s to warn investors aboutfirms at risk of going bust. But it can alsohelp you find the sectors and stocks withthe strongest balance sheets. In otherwords, the ones that are best able towithstand the downturn.

How Z scores workAltmans model is based on analysing thefinancial strength of a company usingfive ratios built on key numbers mainlytaken from a firms balance sheet, alongwith a few from the profit and loss

account. Each ratio is then weighted toreflect its relative importance before thefive are added together to generate a Zscore, usually a single digit figure.

Heres how it works. Weve used figuresdrawn from the income statement andbalance sheet from the 2008 accounts ofFTSE 100 firm Vodafone, purely forillustrative purposes. The ratios are listedin order of importance.

1. EBIT to total assetsThis is the most heavily weighted inother words, the most important com-ponent of the Z score. EBIT is earningsbefore interest and tax, or operatingprofit. This ratio shows how productivea company is in earnings terms, relative

to its size. Basically, it demonstrates howmuch value for money a firm is gettingfrom its assets.

More efficient companies tend to be bet-ter placed to thrive during hard times. InVodafones case, the relevant figures arethe operating profit of 10,047m andtotal long- and short-term assets, whichadd up to 127,270m.

2. Retained earnings to total assets

This indicates the cumulative profitabilityof the firm, again compared to its overallsize. Shrinking profitability is obviously awarning sign. This measure can also indi-cate how highly geared a company is.

High retained profits suggest that a firmmay have financed its assets throughprofits rather than debt. Vodafone does-nt have any retained profits; rather it has81,980m of retained losses.

3. Working capital to total assetsThis compares liquid assets, called

working capital or net currentassets, to the total long (fixed) andshort-term (current) assets from thebalance sheet. A firm in trouble will usu-ally experience shrinking liquidity by thismeasure. In other words, as sales fall orcosts rise, the amount of easily availablecash will fall.

Vodafones balance sheet at 31 March2008 shows current assets of 8,724m,minus current liabilities of 21,973m,giving working capital of 13,249m.

4. Sales to total assetsThis is a measure of how effectively thefirm uses its assets to generate sales.This uses the turnover figure at the top ofthe profit and loss statement for

Vodafone this is 35,478m.

5. Market cap to total liabilitiesThis offers a quick test of how far thecompanys assets can decline before thefirm becomes technically insolvent thepoint at which its liabilities exceed itsassets. For Vodafone, the market cap on4 August 2008, says Digitallook.com,was 72.18bn, while total liabilities(thats the short and long-term liabilitiescombined) come to 50,799m.

You could calculate all of these ratiosand then weight them by hand. But itsfaster to get the relevant figures fromthe balance sheet and profit and loss,then feed them into an online Z scorecalculator, such as the one atCreditguru.com/CalcAltZ.shtml. Usingthe figures from the example abovegives Vodafone a Z-score of 0.364.

What does it all mean?In this case, youd want to avoidVodafone (though bear in mind these are

the 2008 figures). The weaker theAltman score, in particular a readingaround or below about 1.6, the greaterthe chance of a firm suffering financialdistress within the next two years.

While no one is suggesting Vodafone isabout to go bust, Graham Secker ofMorgan Stanley points out that firmswith a Z score of below one have alwaystended to underperform the market,particularly in recessionary periods.Taking the period from 1990 to 2007,the average compound annual growthrate (CAGR) for these stocks was 3.3%against 4.1% for the median stock in themarket. On the other hand, stocks scor-ing between 2.5 and 3 on the Z scoreprovided a CAGR of 6.3%.

by Tim Bennett

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 Universityof 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.

Piotroski score: what makes a good balance sheet?

The Best Recession Stocks

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