Many companies’ fortunes are inextricably tied to the economy, as they rely on supply chains and consumer demand to power their business activities. Investors who are vigilant should be able to pick out signs of corporate weakness just by observing the financials and metrics and reading up on the management discussion and analyses (MD&A).
Here are four clear indicators that can serve investors well as they watch out for red flags impacting the economy. Note that some of these aspects may be company or industry-specific, but if a majority of companies report such attributes, investors can probably conclude that a weakened economy is to blame.
1. Lower profits or profits turning to losses
When companies start to report lower year-on-year profits, this is a sign that economic indicators may be turning down. A strong economy will boost demand for goods and services as people will be gainfully employed and have the resources and means to consume. Conversely, a weak economy results in poorer demand, causing businesses to report lower revenue and profits.
For companies that did not have much profit to begin with, the downturn may cause them to start reporting losses as they do not have any buffer against lower demand for their products and services.
2. Contracting margins
Many companies rely on operating leverage to boost profits during good times, by increasing their proportion of fixed costs versus variable costs. This means that profit margins can expand rapidly during good times, as additional revenue flows directly through to the bottom line. A good example of this would be Straco Corporation Limited (SGX: S85), which runs the Singapore Flyer tourist attraction. This asset has a layer of mostly fixed costs plus some variable running costs such as manpower, so every additional visitor brings incremental revenue that flows through directly to net profit.
However, during a downturn, the converse happens, and profit margins can rapidly contract as Straco is not able to eliminate the layer of fixed cost easily. When margins contract, this may be a sign that times are turning tougher.
3. Order book declining
Contract-based companies such as Nordic Group Limited (SGX: MR7) and Boustead Singapore Limited (SGX: F9D) rely on clinching contracts to continually replenish their order books. This order book represents a backlog of work that will be fulfilled as the months go along. Singapore Technologies Engineering Ltd (SGX: S63) just reported a record order book of S$15.6 billion as of 30 June 2019.
When such companies start reporting persistently declining order books, this may be an ominous sign of a downturn coming. As order books normally provide future revenue guidance, a fall in demand will translate into fewer orders, resulting in an overall lower order book.
4. Falling sector valuations
The final indicator for an impending downturn is when overall sector valuations start to fall. To give an example, the healthcare sector companies may trade at an average of 30 times price-earnings during normal economic times. However, this average may fall to 20 times when a downturn is imminent, as investors are pricing in lower growth prospects for companies within the sector.
The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. The Motley Fool Singapore has recommended shares of Straco Corporation Limited, Nordic Group Limited and Boustead Singapore Limited. Motley Fool Singapore contributor Royston Yang owns shares in Straco Corporation Limited and Boustead Singapore Limited.