Saturday, September 06, 2008

Economic Effects of a Bear Market on Companies

I think by now, any normal man on the street will be all too aware of the effects of an economic slowdown coming to our shores, as well as feel the effects of heightened inflation. The newspaper has been blaring the news out almost every day in a non-stop stomach-churning litany of bad news, contributing to the ever-increasing gloomy sentiment prevailing in the stock markets. But an investor should ask the all-important question: How will these economic events impact on the companies I own ? I would like to address some of these issues here:-

1) Slowing Demand for Goods and Services - With any economic downturn or recession, people will tend to cut down on their spending and conserve cash for a rainy day. This will translate into slowing demand for goods and services across most sectors, but particularly for consumer goods such as electronic goods, cars and restaurant dining. Thus, during a downturn, such consumer-related companies typically feel the effects first-hand as consumers may spend less and eat more at home. Ironically, it is the spending effect which helps to grow GDP for a country (though it may not be good for an individual's wallet or personal finances, but that's another story !). There will be higher unemployment, more retrenchments and even pay cuts/freezes which will make people tighten their wallets further. All these contribute to the contractionary effect on the economy.

2) Higher Cost of Goods - Inflationary pressures and the global commodity boom has raised the cost of goods for many companies. These include the prices of tin, steel, wheat, rice as well as oil. Even though oil prices have come down somewhat to the current US$106 per barrel, they are still much higher than a year ago and the inflationary impact can be felt across the globe. Many companies which rely on oil as an important component of their costs (e.g. airlines, plastics industry and semi-conductor companies) are facing an uphill battle in controlling their COGS while maintaining their gross margins. Food companies also face rising cost of materials as the prices of rice, flour and other raw materials has risen tremendously, while they are unable to fully pass on the effects to final consumers as there is a limit to how high they can raise prices without affecting demand adversely. It should be noted that many companies in the food industries have reported lower protfits, with some reporting losses. The inflation rate was 6.5% in July 2008, down from 7.5% for April-June 2008, and estimates are that it will stabilize around 4-5% for the FY 2008.

3) Difficulty in Raising Equity - With the current economic turmoil and risk aversion, companies which require funds for expansion are unable to turn to the equity markets as the demand for IPO has almost dried up in the last 12 months. Most companies have to resort to pulling the plug on the IPO as the valuations they are garnering are not attractive enough for fund raising, while subscription rate may also be dismal, leading the under-writer to have to mop up the rest of the shares. Rather than subject themselves to such conditions, most companies would rather seek alternative methods for raising funds, while waiting for equity markets to recover their footing.

4) Difficulty in Raising Debt - The sub-prime crisis which erupted in the USA since June 2007 has contributed to this phenomenon. Not only are companies "squeezed"when it comes to raising equity, but now even debt is hard to raise as banks are suffering massive write-downs and a liquidity crisis because of weakened balance sheets; thus they are unable to lend as per normal conditions and will screen each potential borrower more stringently. Interest rates are also apt to be higher and the cost of financing may be prohibitive for some companies. Thus, all in all companies may find it increasingly difficult to either re-finance their debt, or to obtain fresh funds for expansion. In this respect, highly-leveraged firms with poor operating cash inflows are more at risk of getting into big trouble, as they have no other source of cash besides financing.

5) Cash Conservation and Heightened Risk Aversion for M&A - More companies will start to conserve cash as a result of points 3 and 4, and this would mean dividends may be cut or not paid at all in order for companies to preserve cash for operations. M&A activity will also lessen as there is higher risk aversion because companies are not willing to pay premiums to acquire in the current climate. A lessening of such M&A activity points to a sluggish economy and may lead to a vicious cycle of even more risk aversion, until some large company dares to step up the fore and declare a major acquisition. Recently, Coca-Cola announced the acquisition of China-based Huiyuan, in one of their largest acquisitions to date. However, such news these days are more the exception rather than the norm. Ironically, it is this period of uncertainty which makes valuations more compelling for acquirors, and companies such as Boustead with a huge cash hoard can take advantage of such conditions to acquire cheaply.

It has to be noted that I have covered the general aspects of an economic slowdown, high inflation, high commodity prices and also the sub-prime crisis. These are the main events dogging companies now as they struggle to grow their businesses and their profits. Some industries are described as "recession-proof" such as luxury goods and staples such as basic food products; but even these will be indirectly affected by a slowdown.

Suffice to say that no company can escaped totally unscathed from these effects, except those with pricing power, market leadership and prudent expenses control. Booms and busts are part of the economic cycle and all companies should be prepared for such cycles. It is the company which can weather the storm which may turn out to be a big future winner, and who knows, maybe even the next blue chip ?

6 comments:

willy said...

Musicwhiz

I have posted my comments in Swiber forum.

I suggest you liquidate everythings before
you going to loss at least 50&.

Let me tell you why

Ezra and Swiber will be gone if oil hit 50 dollars.
Suntec riets you can keep for dividend but the price will go below IPO price soon. Anyway thye dividend is not that great compare to other riets.

The rest it just goes when STI index that is going down.

I know you are fundamentalist but investing is more about science and it is not going against the market even the long run you right. Let the long run come while you nursing your wounds.

I am long enought to tell you that save your money now and come back in early 2010.

You can Ezra at below 50 cents and Swiber at 30 cents. Suntec at 70 cents and many commodities stock at 10% of peak price.

Wilmar will below $1 and First Resource at 10 cents.

Then ride the next recovery.

cheers

Ricky said...

Difficulty is knowing when to plow it back! :)

musicwhiz said...

Hi Willy,

That's probably the most ludicrous suggestion I've heard so far (no offense). Selling everything to a manic Mr. Market so he can buy cheaply from me ? It's strange because as an investor, I believe we should be able to value a company much better than him ! It's his emotions that are getting the better of him.

Anyhow, thanks for the suggestion though I think it's a bad one. Hopefully, you can suggest something more constructive (perhaps contribute to some of the company threads ?).

Thanks,
Musicwhiz

musicwhiz said...

Hi Ricky,

It's almost impossible to know when sentiment will turn and the market will rally. Many people try to time this but have been unable to consistently (nevertheless, they still keep trying). So I'd rather remain vested and ignore Mr. Market.

Thanks,
Musicwhiz

willy1 said...

As I said, your companies research are very well documentated and I enjoy reading it.

Mr Market is panic,look for recovery and see the share price of the swiber and Ezra, if they cannot come back to 1/2 of previous high, it is bye bye.

Share need follower, when big timer sell, you are left with Singaporean picking up with no pushing power.

As I said, Look at previous stars of the last two bull run! Where are they? IF you holding counters like Singtel, or CityDeve at good price I mean,
at 1.20, $3 respectively in the last bear market you can ride it out.

These are blue chips with good historical records and large institution following. They will be back when the economy turn around.

What I am worry for you is that your Ezra will say for years below $1 and they may not give you good dividend year after year.

It all depend on oil price. Below $50 no point of going deep ocean drilling.

Oil services will slow down and stock will linger for years to come with low dividend.

Oil is a funny thing if you are in 1973, oil at above $30 kill the world economy. 35 years later oil touched $145 and on the way down as the world is in credit crisis. The world keep saying that we are running out of oil? There is nothing to say oil will not reach $10 in 1990. Maybe somewhere in between 90 to 10.

$145 is caused by Goldman Sach and huge fund and greed.

Somewhere between 30 to 70 is likely outcome in the next 5 years.

I suggest you do your sum accordingly to it. The excess capacity bulding up during the last year will be coming in 2009 and 2010.

Not very good.

You are right, MR market will vote in the short term and it will be weighted correctly in long run.

But in next two years it is not very good and Mr market will vote during the recovery.

You can see the rebound and there is no spring in it.

I suggest you swap for the best managed, lowest debt and ready to grap good cheap asset reits in these time and even the market is going to be bad for more than 2 to 4 years, the yield you can get will be at least covered 40% of capital invested.

I am looking for it it is coming to the right price very soon. Just need another huge down next year, like Japan yen carry trade or Japan bank run or even some bank scare or insurance run in Singapore,that will offer some of best buy in many years to come.

I repeat you stock selection must be based on 10 to 20 years solid good business with recurring income in good/bad times and giving consistent dividend years after years. Then we can talk about long term.

Buying Singtel at 1.20 is a good buy in long term.
because of 20 million Asia customer that like to talk and near monopoly in Singapore
Buying CitiDev at $3 is a good buy in long term because of the landbank and worldwide hotel

musicwhiz said...

Willy1,

I note that you are somewhat of a market timer and that you focus a lot of price, not value. If a company is good, it can grow over the years; it does not have to follow the boom and bust model that most companies succumb to. You are talking about blue chips and I can't argue that they are stable and good; but they are usually with more limited growth prospects and are more suitable for senior folk and people with retirement funds to park.

For me, with a longer-term horizon, I choose growth companies and some yield as well.

Your views on oil are not necessarily correct and I do not agree. Oil will eventually find its way up again after the effects of the global recession have worn off, because it is FINITE resource. Unless you tell me they can produce crude oil in the lab cheaply, then perhaps the days of E&P will be over !

Regards,
Musicwhiz