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 ?