KYLE WALES: Three metrics to watch to avoid downside risks in investing
Keep your eyes on price-earnings ratio, revenue growth and net debt/Ebitda
We live in turbulent times. Since one of the steepest cycles of interest-rate rises began in 2022, and with a recession on the horizon, the prudent investor’s focus needs to shift from upside potential only towards downside risk too.
The importance of capital preservation is perhaps best captured in a Warren Buffet quote: “Rule number one [of investing]: never lose money. Rule number two: never forget rule number one.” The following are the three key metrics I believe investors should monitor to mitigate downside risk.
Most investors would have heard about the price-earnings (PE) ratio because it is the most commonly used metric to assess valuation. The PE ratio compares the price you pay for a share in the company at any time versus the earnings it is generating.
The measure indicates whether a company is expensive or cheap relative to its peers or history. Thus, when it comes to managing risk it should tell you whether to invest in the asset or not because, regardless of the business’s specifics, the price you pay for the asset determines returns you get from it in future. Even a good business can be a poor investment at the wrong price, while a poor business can be a good investment at the right price.
Overall equity valuations now are not particularly cheap if one considers the weak economic outlook and considerable uncertainty weighing on financial markets. The S&P 500 trades on a forward PE of 17.2 times, versus a historical average (from 1997) of 16.5 times. The forward PE is based on forecast rather than historical earnings.
Compounding risk attached to this indicator is that the forward earnings estimates could be based on rosy expectations. While most investors think a recession is likely in the next 12 months, the market expects earnings for the S&P to decrease 1.2% in calendar 2023 and increase 10% in calendar 2024 (as at March 14).
Most fundamental investors (whether they invest with a value or a growth mindset) try to invest in high quality businesses, even though they may differ on the price they are prepared to pay or the growth rate in revenue and earnings they target.
The characteristics of a high-quality business include a moat, which is the company’s ability to maintain its competitive advantage, high returns on its invested capital and high free cash flow conversion, which is the business’s efficiency in turning sales into cash. Most importantly, it includes pricing power because the company’s capacity to sell its products and services at a profit will determine its revenue growth.
Certain types of businesses have very little pricing power. Miners and other commodity producers are examples. In a “stagflation” type scenario, where high inflation is paired with low economic growth, it is not inconceivable that miners of commodities sensitive to economic cycles might experience falling prices as their costs increase, squeezing profit margins.
That said, investors should not have unrealistic expectations about the business’s ability to pass on price increases, because even the best quality businesses may find it difficult in challenging times such as now.
Unilever, a high-quality business, reported consolidated underlying pricing growth of 11.3% for its financial year ended December, but this was still not enough to offset raw material inflation and came at the expense of volumes, which shrank 2%. However, we expect Unilever to claw back profits by raising prices when raw material inflation slows.
Another key metric to watch is net debt/earnings before interest, tax, depreciation & amortisation (Ebitda), a useful measure as it highlights the extent of debt of a company relative to its operational earnings.
A good example of a company to reference here, one with which most SA investors will be familiar, is Anheuser Busch Inbev (ABI). After its takeover of SABMiller, ABI was saddled with enormous debt. Its net debt/Ebitda rose to almost five times after the transaction, which far exceeded the normally acceptable threshold of 2.5 to three times. Even today, more than five years later, its net debt/Ebitda is a substantial 3.7 times.
High debt is a bad thing, especially now when interest rates are rising steeply to rein in inflation, because debt must be refinanced at higher yields if the company does not have enough cash on hand to settle it as it matures. But according to ABI, the bond portfolio has a very manageable pretax coupon of about 4% with 95% of the portfolio fixed rate, a weighted average maturity of greater than 15 years and no relevant medium-term refinancing needs. We believe this debt profile substantially reduces the risk of a big debt burden becoming unsustainable.
In good times, investors are almost always rewarded for taking additional risks. In bad times, taking on additional risk can be detrimental to investment performance. Investors need to be aware of the risks they are taking, and protect themselves as far as they can to achieve superior, long-term returns. These three measures give you crucial insight into the potential performance of assets you are considering adding to your portfolio.
• Wales is a portfolio manager at Flagship Asset Management.
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