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Company analysis in a downturn
Wednesday January 16, 10:45 am ET


Faced with a bear market, the gut reaction of many investors is to pile into 'defensive' sectors: global tobacco stocks beat general retail by 32 per cent in 2007. But discriminating between companies matters too. In a bleak 2002, the best performing stock in each US sector outperformed the worst in its sector by 55 per cent on average using FTSE's index. Avoiding blow-ups is critical also. Ericsson and Nortel (NYSE:NT) jointly cut about 1 percentage point off global equity returns from their 2000 peak to trough.

Selecting defensive stocks means abandoning the bad analytical habits that have prospered over the last two years (fans of buy-out simulations, that means you). Instead, scrutiny of three factors may prove important. First, operating leverage, or the sensitivity of profits to changes in sales. This is often measured by the proportion of costs that are 'fixed' and thus hard to cut if sales fall. But low margins are also dangerous. Take two companies, both with half of their costs fixed and both facing a 5 per cent decline in sales. Lame Inc with 5 per cent margins will see profits half. Awesome Co, with 10 per cent margins, will only see profits decline by a quarter.

The second factor, financial gearing, amplifies operating leverage for equity holders. Quoted companies overall have lower net debt relative to profits than in 2000-2003, although profits are cyclically higher. In any case some individual business will need to cut debt.

How quickly this process takes is largely determined by the third factor, liquidity - or the cash and unused borrowing facilities a company has access to. Indebted businesses with heavy refinancing needs are much more likely to resort to damaging firesales and freezes on capital expenditure.

There are plenty of other rules of thumb: profits can fall much, much, further than once seemed possible; and the more troubled a company gets, the more economical its executives tend to be with the truth. Sector selection and valuation are critical. But if 2008 does mark the beginning of a bear market owning high margin, undergeared companies, should also help.