Three equity investing metrics to watch

Kyle Wales, Portfolio Manager at Flagship Asset Management

We live in tumultuous times. Since one of the steepest interest rate increases commenced last year, and with a recession on the horizon, the focus of the prudent investor needs to shift away from solely focusing on potential upside towards mitigating downside risk as well.

The importance of capital preservation is perhaps best captured in Warren Buffet’s quote: "Rule No. 1 (of investing): Never lose money. Rule No. 2: Never forget rule No. 1.” The following are the three key metrics which I believe investors should monitor to mitigate downside risks.

Revenue growth

Most fundamental investors (whether of a value or a growth mindset) try to invest in high quality businesses, even though they may differ with respect to the price they are prepared to pay or the growth rate in revenue and earnings they target. Characteristics of a high-quality business include a moat, high returns on invested capital and high free cashflow conversion. Most importantly, it includes pricing power. Revenue growth, especially as it relates to pricing power is therefore key.

Certain types of businesses have very little pricing power. Miners and other commodity producers are examples of these. In a “stagflation” type scenario, where high inflation is paired with low economic growth, it is not inconceivable that miners of commodities for which demand is linked to the economic cycle might see the prices of the commodities they sell decline at the same time that their costs increase. This will lead to a squeeze in margins.

That said, investors should also not be unrealistic in their expectations. During times such as the current time, even the best quality businesses, may not be able to pass through cost inflation immediately.

Unilever, a very high-quality business, reported consolidated underlying pricing growth of 11.3% for its financial year ended December 2022 but this was still not sufficient to offset raw material inflation and came at the expense of volumes which shrank by 2%. However, Unilever will continue to put price increases through when raw material inflation slows.

Net debt/EBITDA

Another key metric to watch is net debt/EBITDA. A good example of a company to reference here and one with which the South African investor will be familiar is Anheuser Busch Inbev (ABI).

Post its take-over of SABMiller, ABI was saddled with an enormous amount of debt. Its net debt/EBITDA rose to almost 5X after the transaction which far exceeded the normally acceptable threshold of 2.5-3X. Even today, more than five years later, its net debt/EBITDA is still a substantial 3.7X.

High levels of debt, especially in the current environment when interest rates are on the rise to rein in inflation, are a bad thing because debt has to be refinanced at higher yields if the company does not have sufficient cash on hand to settle it as it matures.

In ABI’s case, however, their “bond portfolio has a very manageable pre-tax coupon of approximately 4% with 95% of the portfolio fixed rate, a weighted average maturity of greater than 15 years and no relevant medium-term refinancing needs”. This reduces the risk of a large debt burden substantially.

Price/Earnings ratio

Regardless of business specifics, a significant risk mitigant is always the price one pays for an asset. Even a very good business can make a poor investment at the wrong price, while a poor business can be a good investment at the right price. The price/earnings ratio is the most commonly used metric to assess valuation.

At current levels, overall equity valuations are relatively cheap if one considers the weak economic outlook. The S&P 500 trades on a forward P/E of 17.2X versus a historical average (from 1997) of 16.5X. (The market average is 20 to 25. Anything above is regarded as weak growth, and anything below is regarded as stronger growth.)

Compounding the risks attached to this is that forward earnings estimates do not appear particularly low. While most investors think that a recession is likely in the next 12 months, the market expects earnings for the S&P to decrease by 1.2% in calendar 2023 and increase by 10% in calendar 2024 (as at 14 March 2023).

In good times, investors are almost always rewarded for taking additional risks. In bad times, assuming additional risk can be very detrimental to investment performance. Investors need to be aware of the risks they are taking and protect themselves as far as they can if they want to achieve superior long-term returns.