Leading up to any recession in the UK, or in the wider world economy, I don’t want to be holding shares in a company that operates a cyclical business. The problem with cyclicals is profits, cash flows, dividends and share prices can all plunge when an economic downturn arrives. So I’m watching out for warning signs in the news flow from cyclical enterprises, such as Europe-facing building materials supplier SIG (LSE: SHI), which issued a trading update this morning.
To put things in context, SIG’s share price has been sliding since the beginning of 2018 and is down around 38%, which implies investors have been nervous for some time. Today, the price dropped 7% or so in early trading, and that hasn’t made me feel any less nervous about the firm’s trading prospects than I already was.
Attractive if you time an investment right?
SIG operates as a distributor dealing with trade customers “across Europe” supplying insulation, roofing, air handling products, and stuff for the inside and outside of buildings. The thing I like about distribution companies, in general, is that they offer investors the chance to ride the fortunes of a particular industry or sector without getting involved in the operational challenges faced by firms that deal with the customers at the end of a supply chain. In other words, firms such as SIG just ride the economic activity generated by its customer-companies such as builders, developers and maintenance organisations.
SIG skims revenue from the activity of its customer-companies, regardless of whether those firms actually make any profits themselves. As long as those customer-firms are turning over revenue and installing things, that’s all that matters to SIG. In some ways, its business model is a bit like how the government’s tax system works. VAT, payroll taxes and the like skim tax revenue from business activity regardless of whether firms make any profit or not. But that kind of setup works both ways. If SIG’s customers find business declining because of an economic downturn, its business will downturn as well.
Challenging trading
Today’s trading update covers the whole of 2018 and mentions “challenging market conditions and lower trading revenues” in the second half of the year, which I see as a red warning flag. Like-for-like revenue came in 2.3% lower than the previous year. Despite that, the company expects its current turnaround plan to deliver “a further significant increase in profitability in 2019.”
Revenue slipped almost 6% in the UK, an area that accounted for around 44% of all revenues last year. In the rest of the European trading areas, revenues were either flat or up in single-digit percentages. The directors point to macro-economic uncertainty, slowing house-price inflation, and slowing secondary housing market transactions in the UK as reasons for the second-half decline. The weaker trading environment “impacted on demand for SIG’s products,” it said. Indeed, SIG is trading just as I’d expect a cyclical to trade and responding to the cyclical winds of the economy.
There’s a big lump of debt on the balance sheet, which could prove problematic if a downturn gains traction from here. So, despite the high-looking dividend yield, I’m avoiding shares in SIG. I would rather spread my risk by investing in a diversified index tracker fund, such as one that follows the fortunes of the FTSE 100.