Evaluate Tight Credit-Market Risk
With the credit markets tight, if not stuck completely, it’s important to
evaluate each of your stocks for credit risk. Here’s why.
As you probably know, the credit market problems stem from bad mortgage
loans that were bundled and sold to all sorts of investors, including
corporations. As a result, some corporations holding bad loans failed. The
seeming unpredictability of those failures, in turn, made investors
reluctant to lend money to anyone.
These events can affect your stocks in two ways.
First, they may hold risky investments on their balance sheets that will
eventually have to be marked down. Such markdowns would, at the very
least, sink a firm’s share price.
Second, the tight market will make raise the cost of borrowing for
corporations as well as for individuals. The resulting higher debt
servicing costs will pressure corporate profits. In the worst case, lack
of available credit could force companies to cut back on expansion, or to
even scale down current operations.
There is no website or report service available for
looking up these types of risk for individual stocks. You are on your own.
You have to do it yourself. Here are my
ideas for checking on the risk of your stocks.
You don’t have to consult a website to know that banks are still risky
business. Although many have already been hit hard by bad credit
write-offs, nobody knows how many shoes are left to drop. Further, the
sagging economy will undoubtedly trigger credit card losses. Thus, U.S.
banks are all inherently risky from a balance sheet perspective. Some, but
not all foreign-based banks may be an exception. They are not as exposed
to home mortgage and credit card issues as U.S. banks.
Insurance companies typically invest billions of policyholders’ dollars in
the stocks and who knows what else. Since securities backed by subprime or
otherwise risky residential mortgages were originally termed “investment
grade” by the rating agencies, it’s reasonable to assume that many
insurance companies put money there.
Debt Refinance Risk
Firms that rely on debt to finance their operations must eventually
refinance that debt. As already mentioned, firms that refinance now will
likely incur higher debt servicing costs. The resulting cut in earnings
would pressure share prices.
The debt/equity ratio, which compares debt to shareholders equity (book
value), is a widely used debt gauge. A zero ratio means no debt, and the
higher the ratio, the higher the debt.
You can see the debt/equity ratio on many financial sites. On Yahoo (finance.yahoo.com),
get a price quote and then select
Statistics. Find “Total Debt/Equity MRQ”
under Balance Sheet. You’ll probably be okay with ratios under 0.5, but
lower is better (MRQ means as of the Most Recent Quarter).
Balance Sheet Risk
Firms that generate cash over and above what they need to run or grow
their business usually put the excess cash into relatively safe
investments such as money market funds or Treasury Bills. That cash
typically appears as “cash equivalent” funds on the balance sheet.
However, some firms put excess cash to work in riskier investments that
are listed on the balance sheet as short- or long-term investments. Most
don’t specify those investments in much detail in those reports.
Since, as mentioned earlier, mortgage-backed securities were originally
rated investment grade, it’s possible that short- or long-term investments
listed on a corporation’s balance sheet may include problematic
mortgage-backed securities. Such assets are likely to be marked down,
which, as mentioned earlier, would likely to sink a firm’s share price.
Finding Balance Sheet Data
You can see your stock’s balance sheet on Yahoo by selecting
Sheet on the Financials menu. Select Quarterly Data to see the latest
Compare the total of short- and long-term investments listed on the
balance sheet to the current assets, which includes cash and items likely
to convert to cash within a year such as inventories and receivables.
In most instances, not all short- and long-term investments listed will
have problems. As a rule of thumb, consider balance sheets where the
current assets exceed the total of short- and long-term investments as
relatively low-risk. However, once short- and long-term investments
significantly exceed current assets, you’re getting into risky territory.
To put these numbers in perspective, as of June 30, 2008, insurance giant
AIG, which was taken over by the U.S. government, listed short- and
long-term investments totaling $904 billion compared to only $95 billion
of current assets. Investment banker Lehman Brothers, which recently filed
bankruptcy, on its May 31, 2008 balance sheet, listed short- and long-term
totaling $564 billion vs. $61 billion of current assets (not counting
Still Recession Risks
These guidelines will help you avoid stocks at risk of suffering
from balance sheet meltdowns and from unexpected debt servicing issues
triggered by tight credit markets. However, that doesn’t mean that you’ll
make money on stocks passing these tests.
For instance, most tech stocks are cash rich and don’t access the credit
markets. But that doesn’t mean that a recession-induced slowdown in
computer or cell phone sales wouldn’t sink their share prices. Caution
should be your watchword.