This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.
21 April 2020
We’ve always favoured quality companies and a long term view. That hasn’t changed, but the current circumstances have inevitably caused a short term shift in our criteria.
Revenue sustainability, cost flexibility and access to cash are all more central today than they were just a few months ago. Then there’s the thorny question of valuation, it’s never been an easy one to resolve but in current conditions it’s more difficult than ever.
This article isn’t personal advice. If you’re unsure, please seek advice. All investments and their income can fall as well as rise in value so you could get back less than you invest.
1) Sustainable revenues
Stable and recurring revenues have always been attractive. Keeping cash coming through the door even when times are tough means bills can be paid, debt serviced, profits reinvested and ultimately dividends paid. The contrast between the haves and have nots is becoming startlingly apparent in the current environment.
Transport, travel and entertainment accounts for around 25% of household spending in normal times, but it’s pretty close to zero now. Retailers are unlikely to escape unscathed either – even those with an advanced online offering. Next’s CEO Simon Wolfson hit the nail on the head when he said “People don’t buy a new outfit to stay at home.”
Some more reliable sectors have found themselves among the hardest hit. We’ve always considered London pub group Young’s & Co and contract caterer Compass Group to be pretty dependable. Yes they fall into the discretionary spending category, but a pint after work or lunch in the office canteen is the kind of small luxury most people won’t give up if they have a choice. In the lockdown both have been forced to shut their outlets.
So where do you go looking for companies that can keep cash coming through the door?
Companies that provide essential services to the general public are an obvious starting point – utilities, supermarkets and pharmaceutical groups will all see revenues continue to tick over. Long term contract based revenues, particularly with public sector customers, are also likely to enjoy reasonably robust revenues in the current climate. Defence contractor BAE Systems and GP software provider EMIS jump to mind.
One area we’d urge people to be cautious is technology. Superficially, tech companies look like winners in a scenario where large parts of the world’s population are confined to their home. However, big names like Facebook and Google owner Alphabet rely on advertising spend for a large portion of revenue – in a downturn marketing budgets are usually among the first casualties.
- Do consider companies that provide a vital service to businesses or consumers, or have major public sector customers
- Don't make assumptions about a company based solely on its past record or wider sector
2) Flexible costs
Profits (and losses) have two inputs – revenue on one hand and cost on the other. With the economic backdrop looking increasingly gloomy even the most resilient company is likely to see revenues struggle in the coming months. Maximising profits, or in many cases minimising losses, is going to come down to good cost control.
The real danger here is something called operating leverage. When a company operates with a relatively fixed cost base, additional sales can make a big difference to profits.
Consider the example below. Sales rose 10% between 2019 and 2020, but it didn’t cost the company any more to achieve the extra sales and as a result profits rose 50%. The company is said to have a high degree of operating leverage.
When times are good companies with operating leverage make for great investments. Small increases in sales make for big increases in profits and that can be used to fund future growth or returned to shareholders. However, the same principle works in reverse.
In the below revenues fall by 10%, but because the cost base is fixed, profits have fallen 100% to zero. This is called negative operating leverage, and its effect can be horrible.
In the current environment, where revenues are falling dramatically, a largely fixed cost base could spit out some unpleasant losses.
A flexible cost base helps to limit the damage.
Exactly how much of a company’s costs are flexible can be difficult to find out. Some fixed costs you can look for are interest expenses, lease costs and rent. At least in principle these need to be paid even if the company isn’t generating a penny of revenue. Companies with lots of expensive debt, long leased equipment or rented properties will find it difficult to trim costs.
This is the reason airlines have run into trouble so quickly. Not only have plane passengers all but disappeared practically overnight, but the industry is hugely capital intensive. That’s because planes can cost hundreds of millions of pounds and are usually financed through either debt or long lease agreements. This is an important point, leases might not be formal debt, but they’re pretty similar and should generally be treated as such.
One interesting thing about the coronavirus outbreak is that some costs we would usually think of as fixed have turned out to be pretty variable after all.
Some retailers – including Primark owner, Associated British Foods – have taken the rather drastic step of refusing to pay rent to landlords. Wage bills have also been much more flexible during the current crisis than you would ordinarily expect. That’s largely down to the government’s furlough scheme which has allowed companies to dramatically reduce staff numbers quickly and without the usual redundancy costs. Young & Co for instance has furloughed all but 29 of its 4,500+ staff.
Furloughing staff and delaying rent payments certainly aren’t good news, and we’d much rather they weren’t necessary. However, they do mean many companies’ costs have been more flexible than we might normally expect.
- Do keep an open mind about wage and retail rent costs
- Don't forget to check leases expenses as well as interest costs
3) Access to cash
“Cash is king” is an old stock market saying. Usually it refers to the difference between cash and paper profits – paper profits can be manipulated, whereas cash can’t.
However, in the current crisis it’s taken on a very different meaning. With many businesses seeing a net cash outflow, companies are living on their reserves. Access to cash is crucial to survival.
So how do we go about assessing whether cash reserves and agreed financing is sufficient?
Many companies have been quick to report their current ‘financial headroom’ or ‘liquidity’ position – essentially the sum of their cash on hand and agreed debt facilities. It’s a useful starting point.
A very rough approximation of cash operating costs can be worked out by going back to the last set of full year results and subtracting ‘cash flow from operations’ from ‘revenue’ (you’ll find these in the cash flow statement and income statement respectively). Divide this annual total by 365 and you get daily cash costs.
Divide financial headroom by daily cash costs and you get some idea of how many days the company can fund ‘normal’ operations out of its cash reserves.
Now this is extremely rough and ready. For starters it doesn’t take account of any flexible cost the group can avoid, such as inventory, fuel or some staff costs. You can make adjustments to improve accuracy, but this is always going to be a ‘best guess’. Nonetheless it gives you a starting point for thinking about how a group’s cash reserves stack up against operating costs.
Unfortunately nothing is ever straightforward when it comes to investing directly in shares.
When a loan is agreed it often comes with certain conditions attached. These are called covenants. Covenants can restrict how much a company can borrow relative to its profits or the value of its assets. Since spending cash increases net debt (which is the total cost of debt minus any cash the group has on its balance sheet), covenants can mean a company is unable to spend the cash it has without running afoul of agreements with its lenders.
We tend to think that lenders will be lenient with borrowers who breach their covenants in the current climate. There’s no guarantee though, and having the future of your investments in someone else’s hands is an unpleasant experience. You should be able to find details of any covenants in the company’s annual report.
- Do remember that cash is king in this environment
- Don't forget that covenants matter too
For a more detailed discussion on covenants see our recent article on financial jargon.
We cannot impress on investors hard enough the danger of backward looking financial ratios in current conditions.
Most commonly available financial ratios, including those on the HL website, are backwards looking. We’re talking about PE ratios, PEG ratios, price to book ratios and even dividend yields. They take last year’s number and divide it by the current share price. Given the global lockdowns and deteriorating economic outlook this year’s profits are unlikely to look much like those achieved in 2019. So these historical ratios give a very unrealistic view of reality and they should not be looked at in isolation.
There’s no easy solution to this problem. Investors need to form a view on how sustainable profits will be in the current environment. We try and highlight some of the major issues through our share research, but ultimately it’s something each investor has to decide for themselves.
However, one thing that might make the process easier is thinking about earnings yields rather than PE ratios. These are two sides of the same coin, but we think an earnings yield is a little more intuitive at a time when valuations are changing quickly.
You calculate an earnings yield by dividing earnings per share by the share price. It essentially tells you your share of profits as a proportion of your original investment.
Earnings Yield = Earnings Per Share/Share Price
You can think of an earnings yield as a little like an interest rate. It’s the return you expect to make from your investment in a single year, assuming valuations remain unchanged. Now unlike an interest rate on cash, investing in stocks and shares means there are additional risks involved including your capital being at risk so you might get back less than you invest. Yields are also variable and aren’t a reliable indicator of future income.
We think that this clearer portrayal of potential returns is valuable at a time of heightened risk. It’s important to have a clear picture of what you hope to get in return for your investment, and whether it’s worth the additional risks. Past performance is not a guide to the future and if you’re at all unsure you should seek advice.
- Do remember that historic earnings are very unlikely to be repeated this year, and historic valuations can be worse than useless
- Don't just give up on valuation completely
5) One important caveat
Everything we’ve discussed above is about companies that can weather this storm well. Companies we won’t wake up worrying about in the morning. However, the most profitable investment in the short term won’t usually fall into that category.
A company on the brink of bankruptcy that survives would likely see its share price bounce dramatically, delivering spectacular returns. However, most companies on the brink of bankruptcy don’t survive. Unless you’re buying a very diversified portfolio of companies you’re very likely to lose money in a ‘dash for trash’.
At the moment we’re in the business of picking survivors not winners. We think it’s easier, and at a time when investing is difficult, every little bit of help matters.
This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.
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