Ways the Economy Can Alter Your Fundamental Analysis
Incorporating the economy’s health into your fundamental analysis might seem like a daunting task. How can you consider something as grand as the U.S.’s economic growth when you’re poring over one company’s financial statements?
Still, it’s important to recognize the economy can have big-time effects on business, especially in regard to a company’s:
- Ability to service its debt: A company’s level of debt might look very manageable during normal economic times. In fact, companies carrying a bit of debt will often generate higher returns for stock investors. But that debt can come back to haunt companies when the economy slows.
It might be easier to understand how a poor economy can turn debt into poison for a company by thinking about a plain, old mortgage. Let’s say a young couple making $50,000 a year takes on a $1,000-a-month mortgage payment. That’s really not too onerous. But if one breadwinner in the family loses a job, and the couple’s annual income falls to $25,000 a year, suddenly that mortgage payment is going to be a big nut to deal with every month. The same concept goes for a company. If the economy causes net income to fall, what had been a manageable level of debt might become difficult to handle going forward.
- Capacity to borrow: During the credit crunch, which intensified in 2008, many companies were no longer able to borrow at favorable interest rates or to borrow at all. That unavailability of capital caused many companies to have to finance, or pay for, their expenses and needed improvements out of their cash balances. What if they didn’t have much cash? Welcome to bankruptcy court.
The opposite happened in 2010 and later. Short-term interest rates were left at nearly 0% for about seven years, encouraging companies to borrow. All that changed in late 2015 when the Federal Reserve raised short-term interest rates. The Federal Reserve is the central bank of the United States. It has the power to make decisions that can affect companies’ revenue and earnings, and therefore is one of the most powerful forces for fundamental analysts to pay attention to. Fundamental analysts need to factor in this important change into their models.
During severe economic contractions, the companies with access to large sums of cash are often able to make moves to improve their position when the economy ultimately heals. Walt Disney, for instance, invested heavily to upgrade and expand its theme parks amid the 2008 recession. When the economy improved, the company benefitted greatly as the parks were able to raise prices and boost profitability.
Some companies may also use their cash to buy weaker competitors, giving them greater market share when the economy improves.
- Cost structure: Some companies are able to adjust their costs and expenses rapidly during a downturn, usually by laying off workers. Yet other companies, which are capital intensive or reliant on large and expensive facilities, may have a more difficult time reducing their overhead costs. Closing a plant or facility may take longer than just giving a bunch of workers pink slips.
- Reliance on a strong economy: Some industries are more subject to the health of the economy. For instance, companies that make durable consumer goods such as homes, appliances, and automobiles, usually see the largest drop-off in business as spending on such big-ticket items cools. Companies with profits that are closely tied to the economy are described as being cyclical.