The near total collapse of the banking system has wreaked havoc on companies across all industries – credit availability, the lifeblood of the economy, evaporated almost instantly. Consumer and business confidence crumbled under the sheer weight of negative economic news, bringing retail and industrial demand to a near halt.
Companies considered mainstays of the British economy have been forced to seek funds from the Government or investors to stay afloat.
There has been a paradigm shift and investors’ strategies have had to adjust rapidly to the changing landscape.
There is now an increasing focus on the financial stability of large-cap stocks which can, admittedly somewhat crudely, be split into two categories – those which have net cash or manageable levels of debt and offer stable dividend yields and those that are heavily indebted and may be forced to seek funding or cut expenditures. Depending on investors’ appetites for risk and reward, companies in either category offer opportunities.
It should not be surprising that companies such as AstraZeneca and GlaxoSmithKline lie in the former category.
The large-cap pharmaceutical sector has outperformed the FTSE 100 in the past year as investors sought refuge in defensive earnings. Both stocks offer stable dividend yields in the region of 5 per cent and are still trading on unchallenging earnings’ multiples. Long-term concerns remain about key products coming off patent but investors seem prepared to ignore this in return for short to mid-term reliability.
Another example in this category would be Compass Group, a leading food service business. New management have got the business under control and are wringing out working capital and moving margins upwards. The firm exhibits a strong balance sheet, good free cashflow generation and a decent dividend yield.
For companies with troubling levels of debt, management have needed to act swiftly in the face of falling earnings. Common steps include store/factory closures and job cuts (Marks & Spencer, Johnson Matthey), the suspension of dividend payments to equity-holders (all state-assisted banks), and the postponement of sizeable cap-ex projects (Rio Tinto, Xstrata).
In addition, many companies are now turning to equity-holders for assistance in the form of rights issues. Already, British Land, Hammerson, Land Securities and Xstrata have tapped shareholders in an attempt to improve their balance sheet strength.
This presents a significant opportunity for investors. Many of these companies are solid long-term businesses that have run into short-term difficulties due to having entered the recession with stretched balance sheets. Falling earnings transform once comfortable banking covenants into a serious concern for investors. A successful rights issue could instantly turn such a negative situation into a positive one.
Investors should look for companies with viable long-term business models which may be facing immediate difficulties at depressed earnings’ multiples.
The economic climate will present numerous oppor- tunities for rewards but risks remain high. Investors should act accordingly before the markets settle.
Margaret Lawson is fund manager of SVM UK100 fund