Here are three basic rules you should follow before deciding whether to invest in equities or not.
Leverage
Leverage need not be a bad word, yet investors ought to be careful when it comes to choosing companies whose net leverage is too high — as a general rule, you should avoid companies whose net debt is higher than five times earnings before interest, taxes, depreciation and amortisation (Ebitda).
If properly applied, leverage boosts returns on equity, which is a key financial metric, particularly for such traditional lenders such as Barclays, HSBC, Royal Bank Of Scotland and Standard Chartered, all of which are finding it more difficult to deliver rising returns to shareholders. Decreasing returns are likely to last for some time in the banking world, particularly if regulators keep asking for more stringent capital requirements — lower leverage, that is — as they have done since the credit crunch.
Consumer companies such as Reckitt, SABMiller and Unilever carry some leverage, but that helps them boost returns safely as long as cash flows are stable. Elsewhere, National Grid‘s debt pile is much higher, but this utility boasts a virtual monopoly in the UK and churns out almost £1bn of free cash flow — leverage, in fact, could be more problematic for smaller players in the sector, such as Severn Trent.
Operating Cash Flow
Cash flow from operations — not the cash held on the balance sheet! — is king.
Look for companies whose core cash flows are rising and compare that knowledge with their debt maturity profile.
Not all cash flows are the same: those of miners and oil companies, for instance, are much less predictable and are more cyclical than those produced by consumer companies or even by retailers, the vast majority of which, in normal times, do not need much debt to finance their operations as they profit from favorable terms with suppliers as well as prompt access to cash from their customers.
The big four supermarket chains in the UK are a different story in this business cycle, but net leverage at Tesco, for instance, would become problematic only if Britain’s largest grocer had a much shorter debt duration.
Working Capital
Always look at the balance sheet when you have to assess value, and remember that short-term liquidity and smart working capital management could make a big difference to any investment case.
When margins shrink, and core operating cash flow comes under pressure, companies that are good at managing their receivables, payables and inventories will find it easier to get out of their problems — or they’ll simply be a able to borrow to finance their short-term needs.
Working capital management: that’s what Quindell, for instance, has never been particularly good at. Centrica is a another example of a company that should better manage its short-term liquidity.
Strong companies whose shares are attractive — International Consolidated Airlines is a good example — could have negative working capital, which simply means that the value of their current liabilities exceeds the value of their current assets. That’s not ideal but it may become a problem only when the business cycle turns south, net leverage is too high and the average debt maturity profile is less than two or three years.
Otherwise, negative working capital could be a very smart way to self-finance any business.