Given the uncertain economy, the recent turmoil in the financial services industry and their ultimate effect on global economic growth, I believe it is clearly a time to proceed with caution as an investor.
However, market volatility inevitably creates opportunity. If you are thinking about turning trying times into buying times, here are a few rules of thumb I think you should keep in mind when investing in equities:
1. Focus on organic growth. When economic forecasts are weak, companies possessing the ability to increase their earnings through organic growth (i.e., growth that isn't fueled by acquisitions) could become more attractive to investors. Companies in the early stages of new product cycles or brand line extensions or popular products may offer the best opportunities for organic growth and economic resilience.
2. Focus on companies that make other companies more productive. With productivity gains and resulting cost savings often more difficult to achieve amid macroeconomic headwinds, companies that focus on products and services that offer a "value proposition" could warrant a closer look. For example, oil service companies that possess the latest technologies can charge a premium price because they provide an efficient way to extract difficult-to-access oil and gas deposits.
3. Identify long-term growth trends. Shifting demographic patterns or new legislation can often lead to critical behavioral changes that influence the products and services consumers and corporations purchase. In many cases, companies enjoying either critical mass or "first mover" status reap the benefits of these changes and develop strong customer loyalty, which, in turn, can lead to strong recurring revenues.
4. Seek out companies with financial flexibility. During periods of heightened uncertainty, access to new or additional capital might be more difficult to obtain. Companies that possess the financial strength to fund internal or external growth opportunities through strong and rising free cash flow (and low debt-service costs) will tend to exhibit lower volatility and more stable returns.
5. Avoid companies that need to roll debt or raise capital. Recent market events show that a company that needs to raise capital or roll maturing debt may suffer severe consequences in an uncertain environment. What would normally be a regular occurrence can become a potential sign of weakness in an extremely illiquid market. Furthermore, share price weakness can raise questions about the perceived inability to raise capital and put a company into bankruptcy or conservatorship just as quickly as a lack of financing options can.
6. Pay attention to the quality of earnings. A good measure of a corporation's quality of earnings is how closely its free cash flow (net income + depreciation and amortization +/- changes in working capital - capital expenditures) matches its net income. For a time, a corporation may be able to obscure an underlying deterioration in fundamentals through financial engineering.
7. Scrutinize free cash flow. Free cash flow is one way to gauge a company's financial flexibility. Companies generating excess free cash flow may choose to reward shareholders through the payment of a dividend or a share repurchase program. Other corporations may choose to direct cash flow toward strategic acquisitions or internal growth opportunities. Investors should closely monitor corporations where significant changes in depreciation schedules can have a meaningful impact on near-term earnings. Additionally, a large increase in receivables or inventories can be an indication of potential trouble ahead.
8. Avoid value traps. Consider focusing on forward earnings projections because many economically sensitive companies, particularly at or near cyclical peaks, tend to appear attractively valued based on trailing earnings. Often, particularly during a period of slowing economic growth, the first earnings shortfall may act as a harbinger of future earnings disappointments.
9. Don't dismiss merger and acquisition (M&A) selection criteria. While many investors believe a slowdown in M&A and leveraged buyout activity could lead to a lower stock market valuation, it may not necessarily imply an absence of value. Many of the same characteristics that financial buyers were drawn to over the past several years may remain in place, though in many cases at significantly lower valuations than during previous stronger periods.
10. Focus on the long term and keep your emotions in check. Successfully negotiating difficult market environments requires a willingness to act quickly on investor misperceptions that often occur because of "panic-selling" or "group-think." Emotionally charged markets are often driven by fear rather than the careful analysis of fundamentals. A disciplined investment process " one that emphasizes elements such as strong or rising free cash flow, profit margin expansion, attractive valuation, positive changing internal dynamics and strong management " can go a long way in helping you maintain clarity in volatile markets.
A financial consultant can help you determine if a certain investment is appropriate for you, given your objectives and tolerance for risk. And remember, investing is only part of a comprehensive financial plan.
- William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas Street, Ste. 200 Reno, NV 89509. For more information, call 689-8704 or e-mail William.a.creek
baum@smithbarney.com