The parallels between the current economic fiasco and the Great Depression just keep getting stronger.
Both disasters originated with excessive leverage. In the 1930s, it was overleveraged speculators buying stocks. This time, it was overleveraged speculators buying too much house with too little cash, enabled by overleveraged financial institutions that blindly assumed housing prices would only go up, up, up.
On top of that, poorly crafted government reactions exacerbated both situations. During the Depression, the protectionist Smoot-Hawley tariff triggered global retaliation and contributed to a worldwide recession. More recently, poorly executed bank seizures and excessive subsidizing of failure have distorted the market's ability to correct its excesses. Add a dash of protectionism from the "Buy American" provisions in the recent stimulus act -- and the potential for retaliation -- and you've got quite a foundation for Great Depression II.
But what does that mean for you and your portfolio?
Can you invest through this mess?
Given those parallels, the Great Depression and its aftermath offer us some salient reminders as we slog through today's doldrums:
In other words, take a deep breath. Despite all the gloom and doom (and it's real gloom and doom), this doesn't likely spell the end of life as we know it.
But until the country's debt woes are brought under control, this situation is likely to continue. Right now, the credit markets are still tough to crack for all but the strongest borrowers, even prominent banks are still on the rocks, and the overall economy doesn't exactly look healthy.
All of that doesn't mean you should stay out of the market. In fact, it means that you should be invested in companies that are strong enough to survive -- and that will thrive when the recovery comes.
What to look for
A key characteristic of that strength is being able to stay out of the debt crisis that's hamstringing companies in industries as diverse as finance, automakers, and homebuilders.
With financing as tight as it is today, even profitable companies can be undone by debts if they can't pay them off or refinance them when they come due. Thus, companies that have limited debt or avoided it altogether are far better positioned to ride out these trying times.
But what counts as "limited"? Here are two definitions worth considering:
Below half a year's revenue. This helps ensure that the debt is manageable relative to the overall size of the business.Below the company's tangible book value. With tangible equity (more tangible assets than total debt), a company can offer collateral for secured loans that may be more palatable to squeamish debt investors than typical senior unsecured bonds. That's crucial if the credit market is still frozen when its debt matures.Show me the money!
Just keeping debt at manageable levels isn't enough -- you also want operational strength. That means finding companies that are profitable today and have substantial free cash flows when compared to their reported earnings.
Put together a strong balance sheet with decent earnings supported by cash flows, and you have the makings of a company with a strong chance of surviving today and thriving tomorrow. Here are just a few that fit these criteria and are worth a closer look:
Company
Debt-to-Revenue Ratio
Debt-to-Tangible Book Value Ratio
Trailing Free Cash Flow
(in millions)
Trailing Earnings
(in millions)
Qualcomm (Nasdaq: QCOM)
0.02
0.01
$1,907
$1,679
Western Digital (NYSE: WDC)
0.07
0.18
$528
$487
CarMax (NYSE: KMX)
0.05
0.21
$68
$59
Hormel Foods (NYSE: HRL)
0.05
0.26
$496 Continued... |