If you're worried about picking a share that can survive the credit crunch, look for a company that measures up on these two criteria.
Invest in shares? In this market? Despite the gloomy headlines there are plenty of companies that will be worth buying for the long haul. The difficult bit, of course, is finding them. More important at this stage, I would argue, is making sure any investments you already own are well placed to resist any downturn.
Cheap as chips
Shares are certainly not expensive on traditional valuation grounds at the moment. In the FTSE 100 for instance, you can currently choose from 30 companies on a forward P/E ratio of less than ten. Likewise, there are 31 companies with a forecast dividend yield of 5% or above.
As you might expect there is considerable overlap between these two lists. As well as numerous banks, there are big names like BT Group
(LSE: BT.A)
, Marks & Spencer
(LSE: MKS)
and GlaxoSmithKline
(LSE: GSK)
in there. And despite the soaring price of oil, BP
(LSE: BP.)
and Shell
(LSE: RDSA)
are also present.
In the FTSE 250, the picture is not too dissimilar. Take your pick from 80 companies on a P/E of below ten and 60 with a forecast yield of 5% or more.
Now you could argue that the forecasts on which these stats are based are too optimistic because analysts are yet to factor in how hard earnings could be hit over the next year or two. That may well be true. Yet there is still a substantial margin of safety here.
In the current climate picking shares is more about avoiding the big losers. So what warning signs should you look out for?
Ditch that debt
Avoiding companies that have debt is an obvious way to go. Unfortunately, there are few companies out there that don't have debt of some kind, so you may find this is too restrictive. A better question may be how much debt is too much?
Two ratios can help you out here. The first is gearing and it's measured as net debt divided by a company's net assets. It's usually expressed as a percentage so a company where net debt was £1b and net assets were £2b would be said to have gearing of 50%. An alternative way of calculating gearing is dividing by market capitalisation rather than net assets.
Personally, I would certainly be wary of anything with over 50% gearing at the moment, calculated by either definition. You might want to set your bar even lower. It's worth comparing a company's gearing to its rivals. Any company that has significantly higher gearing than its competitors should be treated with caution.
A second useful ratio is interest cover. This is operating profit divided by interest. So a company with profits of £100m and an annual interest bill of £20m would be said to have an interest cover of 5 times.
This is often a more useful ratio than gearing, as it measures the interest paid over an entire year whereas gearing just takes a snapshot of the debt position at one point in time. So it's more reliable for business where the cash balance fluctuates significantly over the course of a year.
An interest cover of 3 would seem reasonable comfortable at the moment, but again you might feel a higher level of protection is required. Again, look at similar companies in the industry where possible.
As well the absolute level of these debt ratios, look at how they have moved recently. If both gearing and interest cover have been getting worse over the last couple of years, when times have been good, it hardly bodes well for when the economy is slowing down.
It's also worth looking at the debt a company has in more detail. Look at when loan repayments are due and when any debt may need refinancing. I wouldn't want to invest in any company which was looking to refinance a hefty loan in the next twelve months. The level of interest a company pays is also worth noting as this gives an indication of how risky its lenders view its prospects.
Go for attractive models
Having assessed the financial state of the company you're interested in, it's time to assess the robustness of its business.
What constitutes a good business model is a highly debatable subject. If we're looking to guard against a downturn there are two things to watch out for. First, a high level of fixed costs is best avoided. Any significant fall in sales is likely to drop straight through to the bottom line and result in significantly lower profits too.
So you might argue that from our list of cheap FTSE 100 companies, BT is a little vulnerable in this regard. If we make fewer calls, its costs are barely affected. Marks & Spencer is better placed perhaps as its costs are more variable.
However, as well as looking at how profits would be affected, you also need to consider how likely it is that sales will fall. Here BT is probably better positioned than most. It gets a lot of regular income from line rentals and we'll still be using our phones even in the midst of a recession. Marks & Spencer, on the other hand, could be more severely affected. People might put off clothes purchases or, heaven forbid, shop for their food at Aldi or Lidl instead!
Sadly, this is often the way with investing. No one investment will measure up on every test so it's matter of assessing how just much risk you're preparing to accept in return for the price on offer.
