The dreaded “R” word held sway in August 2019 unlike any other time since at least the Great Recession days of a decade ago. Here’s the thing, though: Recessions are difficult to predict, both in occurrence (will it happen at all?) and in timing (if so, when?). Plus, every recession looks a little different. In 2008, it was housing and banks that bore the brunt of the pain. In the early 2000s, it was the internet stock bubble.
So when a recession happens again, it’s anyone’s guess as to who or what will suffer outsized losses.
It’s far easier to assess the health of individual companies than it is the global economy. Thus, it’s always good practice to do a portfolio review, take some profits off the table, and cut out the companies that aren’t doing so hot. As technology stocks have (rightfully) been leading the charge in the markets, this is a good place to start — especially considering that many aren’t running a true profit yet.
Here are a few metrics to monitor when making hard decisions about what to let go, especially if a recession is looking imminent.
Companies with no free cash flow
Many investors keep a close watch on earnings, a simple measure of profitability that conforms with generally accepted accounting principles, or GAAP. Earnings don’t tell the whole story, though, as noncash expenses like depreciation on assets are included in the metric. To figure out if a company’s actual cash balance is increasing or not, investors need to take a look at a company’s free cash flow, money left over after cash operating expenses and capital expenditures are paid for.
Given the definition, free cash flow would be a good place to start when determining whether to sell a tech company if an economic downturn is nigh. A slew of companies report negative earnings yet still post positive free cash flow that largely goes unnoticed by many investors. A few examples of unprofitable businesses that are actually cash flow positive are cybersecurity outfit Zscaler (NASDAQ:ZS), big data company Alteryx (NYSE:AYX), and Shopify (NYSE:SHOP) — which just recently entered positive territory. Simply selling companies such as these because they have negative earnings without a little extra due diligence doesn’t cut it.
Granted, some businesses intentionally run in the red, burning cash off the balance sheet in order to maximize top-line growth. Should a downturn negatively hit results, some might be able to tighten up and save some cash. Many are still small, though, and need the growth in order to climb out of their operating hole. A good indicator of trouble is selling, general, and admin (SG&A) expenses that are well over half of — or sometimes close to equal to — total revenue. When a downturn hits, stocks in that unenviable position are the ones likely to get punished the most by the market. While SG&A expense certainly isn’t the end-all, be-all metric, some stocks that might carry extra risk are Appian (NASDAQ:APPN), Fastly (NYSE:FSLY), and Anaplan (NYSE:PLAN).
Companies with below-average profit margins
Speaking of spending too much money, gross profit margin is another metric to look at if de-risking your portfolio sounds like a good idea. Gross profit subtracts the cost it takes to actually make a product or produce a service. Remember Econ 101? There’s this thing called scale: make too little of a product or service and gross profit is low. As more sales are added, though, average costs fall and profit margins grow. Companies that haven’t yet reached this optimal balance sit in a precarious situation, as it means they have little wiggle room to ride out a storm.
Two that come to my mind are the high-profile 2019 IPOs Uber (NYSE:UBER) and Lyft (NASDAQ:LYFT). For many tech-based service providers, gross profit margins well in excess of 50% are ordinary. Not so here. Through the first six months of 2019, Uber’s gross profit was 45.4% and Lyft’s was 33.5%. An added concern is that, though both are growing revenues by double digits, gross profit is decreasing as they add new lines of business in an attempt to reach a profitable scale. Uber’s year-ago gross profit was 53.3% and Lyft’s was 38.6%.
When you add in SG&A expenses, companies like Uber and Lyft that have low gross profit margins and are operating in the red suddenly look even less attractive during an economic slowdown. Dealing with excessive and inflexible cash burn in times of uncertainty makes managing a business that much harder…
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