The past six weeks have showed that the markets are finally capable of an upswing, but that’s certainly no excuse to blindly throw cash at the next big stock.
Sure, the Dow Jones Industrial Average and S&P 500 indexes have been hitting historic highs. But the Dow’s 30 blue-chip stocks are just a fraction of what’s available to investors, and the S&P is being buoyed by defensive stocks – those that provide constant earnings or a stable dividend – which are usually bigger picks when the economic outlook is poor. And the American Association of Individual Investors weekly sentiment survey showed last week that only 19 per cent of investors are bullish on the market right now – a 16-per-cent drop from the week before.
A global Ernst & Young survey of senior executives sentiment in 2013 suggests that the world’s corporate mindset is changing. Sick of waiting for another economic heyday, companies are finally beginning to search for ways to optimize their business models in a less-than-favorable economic environment. This has key implications for investors: If you’re going to buy stocks, they should be in companies that can prove they can adapt to reality.
“We don’t see any improvement coming over the horizon,” says Barry Levine, associate director at Ernst & Young’s process improvement advisory services practice in Toronto. “Companies are starting to say this is the new normal.”
Many companies were able to survive for a few years after the height of the recession without changing their production or costs, but the study’s participants – executives from 641 companies in 21 countries – said their biggest risk this year is pricing pressure, and that it’s now time to start finding new ways to be profitable.
“The patience of investors has been tried for a few years, and it’s probably going to continue,” Mr. Levine says. While there’s “no quick fix” to this, he says, organizations need to be entirely transparent to shareholders and clearly outline that they’re making strides to raise profits.
“Investors need to be looking for companies that are getting on with the business of optimizing their operation, and resetting their operational levels so they can better sustain the current environment,” Mr. Levine says.
In other words, it’s important to look for companies that are proving their agility – reducing production levels to cut down on inventory, for instance, or cutting costs in inefficient areas of the business. When the good times return, these companies can become even more profitable, if they demonstrate that they can flexible while reducing overhead costs.
As an example, the Ernst & Young study cited logistics company DHL, a subsidiary of public company Deutsche Post AG, which used software and new equipment to reduce its travel distances by 15 per cent, tripling the customer-service awards it received between 2009 and 2012.
Here are seven of the top opportunities the study suggests companies should strive for and, in turn, that investors should look for:
– Innovation in products, services and operations.
– Seeking growth in emerging markets.
– Investing in process, tools and training to become more productive.
– Finding new marketing channels.
– Investing in information technology.
– Being transparent to investors.
– Environmental stewardship.
Vinodh Ramani, a senior business research analyst with Frost & Sullivan consultants, says that in an era of declining profitability, it’s also important to look at companies’ balance sheets and compare their debts with industry averages. Keen investors already know this, but it’s even more important to see how companies have wrestled with the fallout of the recession.
“Those with huge debt compared to the industry average – investors should stay away from them,” Mr. Ramani says by phone from Chennai, India. These companies, after all, will have less cash to turn revenues into profit for shareholders. Of course, a clear debt-reduction plan – particularly one already in motion – helps negate this problem.
Mr. Ramani also suggests carefully monitoring industries as a whole. If most telecom companies in a given market start a price war, for example, their average revenue per user – a key metric in that industry – declines, and “the risk is with respect to the entire sector.”
Researchers at Pavilion Financial Corp. in Montreal have released several reports this year outlining the trends forcing down global equity profitability. Profit margins play the most significant role in declining worldwide return on equity, they found, and determined that in the medium term, “market participants should not expect a reversal of the downward trend.”
Pavilion global strategy head Pierre Lapointe says that while profitability tends to take time changing directions, in the United States, at least, the stock market is already anticipating higher growth. Companies that have adjusted after the recession are now “lean and mean,” he says.
While already-trimmed businesses struggling to cut further costs, “companies’ focus should change to growing sales right now.”
Investors, then, should be looking for companies to boost sales, particularly if they’re buying U.S. stocks, which will benefit from the country’s economy. And worldwide, businesses can even be part of the solution: “Companies have been sitting on huge piles of cash,” Mr. Lapointe says. “If they choose to do something with it, that would be good for the economy.”