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More than a year and a half of concerns about inflation, rising interest rates and extreme government spending have increased the uncertainty of the investment markets. For this reason, it is imperative for seasoned and novice investors alike to protect their portfolios.
I like to call this “bullet-proofing” your portfolio. There are some steps to take that will assist in this process.
The first is to review your stock’s resilience.
During the pandemic, the traditional rules of investing in established companies with strong revenue and profits seemed to have been tossed aside. According to Credit Suisse, one of the best performing styles in 2021 has been the basket of stocks with a high probability of defaulting on the firm’s debt.
Through Aug. 31, the stocks of these potentially defaulting companies were up more than 28% for the year, while the S&P 500 came in around 20%.
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However, in September, the markets provided investors with a reality check. The S&P 500 was down 4.8% for the worst month since March 2020.
What was the issue? Perhaps it was stubborn inflation, the possibility of rising interest rates or even continued supply chain problems, resulting in companies being unable to meet their earnings expectations for the remainder of 2021 and beyond?
As companies begin to report their third-quarter earnings, investors will find out exactly what happened.
If expectations for companies’ future earnings get cut, the market will not be kind, and these companies’ stock prices will tumble. Stocks with the loftiest valuations are the most venerable. It’s time to test your investments’ ability to withstand current headwinds and determine if they are indeed resilient.
A resilient company is one that can weather the volatility that comes with operating during a full economic cycle, including a recession. Will the company survive if its sales or profit margins decrease? Over the long-term, companies, just like your household, need consistent and positive cash flow.
Access to cash typically comes from two places. One source is sales of a company’s product (the company’s operations.) The second is financing through either loans (debt) or issuing new stock in the company.
Companies that have been established for a long period of time should have strong enough sales and profits so that rounds of new debt or stock issuance are not necessary. On the other hand, a company that has a new technology or a non-conventional product may need new financing for several years until its sales and profits become strong.
Both types of companies can be deemed resilient and therefore, less likely to suffer a major pullback in their stock prices.
Taking a deep dive
Now, take a deep dive into the financial health of your investments.
While confirming your investment’s cash flow resilience is a good start, there are a few additional numbers and statistics that can be indicators of potential problems. The following data will further test financial health:
Earnings and revenue growth: Review whether the company’s earnings and revenue in the most recent years are higher than earnings and revenue in previous years. At the minimum, one would want to see that earnings and revenue growth is on a positive trend. Of course, companies that are considered innovators in technology or medicine may need to be given some leeway.
Levels of debt and stock on the balance sheet: Compare the current dollar amounts of both debt and stock on the company’s balance sheet to the past two to three years. Are either of these increasing significantly from one year to the next?
Next, review the company’s revenues and net income, both of which can be found on the company’s earnings statements. Are these decreasing?
If the answer is yes to both of these questions, the company’s cash flow from its operations is declining and they are making up the difference by going to the bank — and/or shareholders.
The good news is that you don’t need to be a financial analyst to find the answers to the above questions. The information is readily available through quarterly earnings announcements. Search the company’s website or review past financial press releases.
Now that you understand the numbers, you need to know how and when to play it safe and when to take risks.
Companies are starting to warn that the consequences of inflation and supply-chain bottlenecks will create an inability to meet expectations from Wall Street. Over the past three months, profit margin estimates have been decreased for 140 companies in the S&P 500. When sales or profit estimates are cut for a company, so is its stock price.
We are entering a period where companies that disappoint will be punished more severely than in the past. The reason for this is extreme valuations and stocks that are priced for perfection. In preparation, understand your company’s degree of financial strength during a complete economic cycle.
Evaluate your company’s pricing power, its inelasticity of demand for its goods and services, as well as its ability to meet current demand. Also, estimate how the metrics that were highlighted above will be impacted during a longer period of inflation and lower growth.
With your new understanding of your investment’s cash flow resilience and financial metrics, you are ready to determine how much you can potentially make or potentially lose when it reports its earnings in just a few weeks. Failure to do so may result in harsh penalties.
There are also steps you can take to preserve those gains.
How to hold onto gains
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Approach your portfolio of companies in the same manner as an institutional manager by estimating how much upside and downside that the stock may have over the next 12 months.
Evaluate how lower sales and/or decreasing profit margins may affect the share price. Go back and look at how the company has fared during past recessions or lower profitability.
It’s not a complicated calculation. Spreadsheets are not required.
If your estimated upside percentage is the same or lower than the estimated downside percentage, take profits and or sell the position. For example, if you think that there is only a 10% upside for the stock over the next 12 months, but your potential downside is 15%, then by all means, sell some.
If you are uncomfortable with percentage calculations, review your company’s estimates for its earnings and watch how your stock’s price is acting in the market. If the markets are pulling back and if your position is falling, set a point where you sell all or part of it. If markets keep moving upward, review the stock’s price estimates. As the price gets closer to the consensus target and if you agree with the analysis, take some profits.
The past 18 months have been profitable and relatively easy for investors. However, economic and political uncertainty is increasing the chances for a market correction — and watching your gains disappear.
Now is the time for investment discipline. The strategy outlined above will provide this discipline.
If you confirm your investment’s resilience, understand its financial health and determine if selling is warranted, you will have a higher probability of retaining the money that you have made and reaching your long-term investment goals.
While investment managers are more rigorous, they basically go through the same steps. Now you have a strategy to hang onto your hard-earned profits.