Does investment research have blind spots; big issues that go under the radar?
Behavioural finance points to a tendency to pay less attention to data that is ambiguous or abstract. Analysts see meaning in sales and profits, but often struggle to factor-in debt and credit. The concept of interest charges rising for companies - and even the national accounts for countries like the UK - is counter-intuitive, after the rate cycle has peaked. Unsettling information is less common in analysts’ reports.
Bank problems are just one early sign of a growing liquidity squeeze. Evidence of bad lending will soon emerge. Easy money has propped-up poor business models for years; actual failure takes time. As losses mount, many early stage growth businesses have cut back on marketing and other costs to extend their cash runway. And some older declining businesses, trapped within a high cost structure, have allowed debt to pile up. Indeed, for mutual organisations, borrowing may be the only finance available.
It would be wrong to think this is all about technology and innovation. Investors should also question sectors such as real estate that embody significant leverage. The boom in alternative assets has brought some innovative financial structures; what was once exotic has moved into the mainstream. Few parts of the economy will escape the rise in real interest costs that accompanies widening credit spreads and falling inflation. Over the next 12 months, the Bank of England interest rate is likely to move in the opposite direction to the real borrowing costs of many businesses.
Analysts face multiple challenges in spotting the problems, never mind calculating the actual impact. Less attention is placed on accounting for cashflow, which can be weak even as reported earnings per share seem to be growing. Acquisitions and restructuring allow a lot of flexibility in accounting to make adjustments, and can disguise cash raising.
Parts of the economy that seem to have operated without cash, could see change. Some apparent cash savings such as share-based compensation – can make earnings per share look much better than they would treating these rewards as a business cost. The recent fall in share prices of technology businesses will challenge this model, with key staff likely to look for rewards in real money. Lower share prices now rule out further takeovers for many companies, which will highlight cash burn and poor organic growth. Talent will head towards more-established profitable companies.
Before companies actually fail as cash runs out, it is likely business models will change, compromising growth. Many companies have burned cash to attract customers or subsidise essentially uncommercial service offerings. Liquidity tightening will force this to be recognised, and encourage customers back to more traditional incumbents. Some e-commerce businesses will calculate that the cost of product returns means much of their activity is loss making. And the neo-banks that aim to undercut older established banks may find they lack genuine competitive edge. It is hard to make a viable business out of unprofitable cash withdrawals and currency transactions. Supermarkets can tweak their customer offerings – say, by reducing rewards – but new businesses often have little customer loyalty to rely on.
Studies show the importance of salience in how information is processed. What gets attention in company reporting is not necessarily what matters most - at least not at this stage in the economic cycle. Company narratives, adjusted earnings and 52-week share price highs can carry undue weight in investors’ thinking. There are likely to be considerable lags in reporting rising debt, interest costs or erosion in a business model. Investors should now look beyond the preoccupation with growth and earnings per share to consider how companies can cope with a liquidity squeeze.
A version of this article was published in Citywire on 13.4.2023.