Taking Sick Stocks’ Temperature

Taking Sick Stocks’ Temperature

| April 20, 2020

As you’ve surely noticed by now, I’m confident about the long-term strength in the economy, even if the short-term outlook is virtually unknowable. But as much as I believe in the economy, it’s naïve to think every stock will survive this crisis and go on to make that hoped for V-shaped recovery. Some companies will be permanently impaired. Others will need to merge. But some may be terrifically undervalued—the babies thrown out with the bathwater, if you will. Those will be the stocks we’ll all wish we had the foresight to buy someday.

There’s no one surefire way to assess a stock’s health and resilience. Distressed companies need to be analyzed differently from thriving companies. Thriving companies are valued according to their expected future cash flows. When companies are distressed, analysts first want to know if they can avoid bankruptcy or, if not, what their liquidation values might be. Only then should they think about upside. Here are a few considerations for companies that are taking it on the chin from this pandemic.

Earnings are a barometer of changes in shareholder wealth, but they aren’t cash. Earnings include sales that were made even if payment wasn’t yet received, for example. They can also include expenses that haven’t been paid out yet. When times are tough, cash is king. For that, investors will want to look at the statements of cash flow, which reflect money that flowed in and out of the company. Companies need cash to pay interest on the debt they owe and the expenses they generate. If a company is burning cash, then the company might not be able to sustain a dividend or worse.

The next stop might be the firm’s balance sheet. Does the firm have enough cash and cash equivalents to sustain operations, and for how long? If not, some companies have emergency credit lines they can tap. In healthier times, firms could issue bonds and refinance their debt. That might not be the case now. While looking at the balance sheet, compare current liabilities with cash and equivalents. Those are the bills that will come due in a year or less. If the company’s revenue has plunged, can the firm make those payments? In more stable times, we’d compare current liabilities to current assets, but current assets include accounts receivable. A firm’s customers might be slow payers, and that can lead to a cash crunch.

The government, particularly the Federal Reserve, is pumping cash into the system through bailouts, stimulus payments and even buying troubled debt. That will prevent many companies from going under. But it can’t shield all of them. Monitoring your holdings’ cash positions and “burn rate” if they are currently losing money, is a wise step to take. And then, once you’ve taken whatever steps necessary to manage your downside risks, then it will be time to look for the upside once again.