Some investors look for long-term income stocks, some try to capitalise on upcoming growth stocks. And others love a good recovery opportunity when one comes along. In the aftermath of the 2020 stock market crash, recovery investors are surely having a field day. It’s party time for contrarians.
The FTSE 100 is down around 18% so far in 2020. And while rises or falls of 100 points used to be something worth commenting on, these days they regularly happen before lunch with nobody even noticing. But even in today’s depressed state, the Footsie is still up 25% from its low point in March. That month, the UK’s top index dropped as low as 4,898.8 points — something many of us never expected to see.
Some recovery investors will have already made some nice profits. But there’s surely a lot more potential recovery to come. I definitely agree, but I’ll also urge caution, based on that well-known suggestion from Warren Buffett: “You only find out who is swimming naked when the tide goes out.“
What he means is that the outgoing tide of an economic downturn will show up which companies are living precariously. Is there really the cashflow there to cover a company’s reported earnings? Is all that talk of growth potential or progressive dividends supported by a robust balance sheet? A time of recession is when the spectre of potentially deadly debt can become actually deadly.
Debt is a killer
So the first thing I’d do with every recovery prospect I examine is closely scrutinise its balance sheet. It’s tempting to be attracted by a company’s boasts of how much it has in the way of undrawn credit facilities. And sure, that’s a plus to have when a firm is under financial pressure. But what it might really mean is “we’re up to our neck in debt, but we can still go a bit deeper.“
So check that debt. What is it like as a multiple of earnings? Is there sufficient cash flow to service any debt? And here’s a potential big red light for me. Is the company paying dividends while carrying big debt? I hate that. It means a company is effectively borrowing money to hand out as dividends. It’s risking its long-term survival to satisfy short-term desires.
Recovery timing
Recovery investors often make another mistake too. They get in too early. Markets always overreact, and it’s often true an initially oversold crash can be the best time to get in and make the biggest profits. But that requires a company to actually survive and make it out the other end of the downturn. Many don’t.
So, before I’ll take on a recovery investment, I want to see an actual recovery in the company’s figures. I want to see it past the worst and heading up the exit slope. I know I’ll miss the biggest potential profits that way. But I’ll also greatly reduce my chances of a wipeout.