Like the ocean’s tides, financial assets like stocks and bonds move in broad, predictable cycles. While predicting the move of an individual stock can be like predicting an individual wave, the broad cycle makes sense.
After rallying relentlessly for over eight years now, stocks appear to be at a high tide. Time will tell if they’ll start receding, or if they’ll continue to reach for new all-time highs. But what matters most to investors is what happens when the tide starts going out.
And when the tide goes out, to paraphrase Warren Buffett, you’ll see who’s been swimming naked. In the stock market, a rapid decline can show many things. It can show how weak many companies truly are.
That may be from having a weak balance sheet that can’t deal with a downturn either by having too little cash or too much debt (it’s usually both). It could also be from a company whose product is sensitive to changes in the economy and may see a steep decline in sales or profit margins as a downturn unfolds. It could even come from an acquisitive company that needs to write down how much they overpaid to buy an entire company in the first place (an accounting term known as goodwill).
We’ll see all three in the next downturn, whenever that occurs.
There’s also a seedier aspect as well. A declining stock market and economy tends to show where companies have been less than above-board in their operations. Accounting scandals at Enron and WorldCom didn’t break during the 1990’s. They broke after the economy peaked in 2000. In a recession, there’s no real growth at a company to hide fraudulent behavior that may have crept up over the years.
Executive compensation and perks can also come into the limelight after a company’s business turns south. Sweetheart deals on gas wells and corporate spending on perks like fine art at Chesapeake Energy (CHK) led to the ouster of founder and then-CEO Aubrey McClendon in 2013. It doesn’t take much research to find an avalanche of articles praising McClendon’s leadership while share prices were soaring.
Bottom line, there are many ways a company can inadvertently set itself up for trouble while things are going well. Some are legal, some aren’t. The truth will always come out though.
Naturally, the question begs itself: If we’re at high tide for the markets (or near it), what’s an investor to do to protect against declines and possible fraud? There are many things to consider.
First, it’s easiest to see what a company’s doing to set itself up for failure on the legal side. A company that has been increasing the amount of debt it has could run into trouble. Higher debt means more leverage, and a higher amount of cash flow needed to pay down the debt. The principal for that debt payment could come at an inopportune time. Many companies tend to roll their debt, and the credit markets might not always be as accommodating as they are now.
In a worst-case scenario, the bills come due, there’s no money to pay and no hope of a loan. That leads to bankruptcy, which tends to severely punish bondholders and cause a total or near-total loss for stockholders.
If a company’s been using the debt to make acquisitions, investors should look to see if those acquisitions add to the company’s bottom line in terms of new cash flow and higher profit margins. If the economy hits the skids later in the year, for instance, then Amazon’s (AMZN) offer to buy Whole Foods Market (WFM) will look in hindsight like the kind of mistake companies make when they’re too optimistic at the peak. However, allowing the company to expand into the grocery space could expand its market share over time, and could end up benefitting in the long term, even if there’s some short-term gain now.
The biggest problem with today’s debt, however, is a familiar one. Companies have been using low-cost debt to buy back shares. In recent years, nobody’s been more bullish on stocks than corporations themselves. That’s not always a problem, if a company has the cash flow to buy back shares and sufficiently reinvest in their business. But taking on debt to buy back shares at a slow-growth company could eventually create a problem for investors.
When it comes to investing in companies, there’s not necessarily anything wrong with buying shares of a company whose debt load is increasing. But I’d be wary of companies that have historically high ratios of debt to equity. It’s a worthwhile financial metric to screen for, and it’s easy to find when researching a company.
On the illegal side of corporate behavior near market peaks, it’s a different story. If you could find a way to screen for illegal behavior, the behavior would already be publicly known and factored into the share price. But there are several yellow flags for investors to consider.
For instance, it’s normal for a company to have “one-time” events that may impact earnings, like the sale of one of its divisions to another company. But if a company keeps having “one-time” events on a regular basis, they either don’t have a better category for these items, or they’re using it as a means to adjust earnings now to show the results they want. Either way, it’s a yellow flag worthy of future research.
Secondly, it’s somewhat easy to track bad behavior at the corporate level. Is the CEO loading up the Board of Directors with friends? If so, there isn’t much independence on the board and as a result they may be willing to rubber-stamp lavish perks for executives as well as themselves—to the detriment of the shareholders who own a stake in the first place. Any company whose CEO is featured in a business magazine showing of an excessively lavish lifestyle might not be a toxic glow cloud, but it should be avoided.
It’s a challenging time for markets. We’re still in rally mode, and investors are starting to move towards greed. It’s getting on high tide. Stick with underleveraged companies with low-key management focused on doing what’s best for shareholders, and you’ll make out fine no matter what the economy does.
Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and writes the monthly newsletter Crisis Point Investor.
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