To Pick a Stock in Today’s Market, Think Spring and Levers

Thursday, February 11, 2010

Coiled springYesterday, I outlined “12 Steps To Getting Your Investment Mojo Back“.  Today, I want to discuss finding leading stocks that meet the characteristics discussed under the “Take action” section.

One approach is to identify leading, dividend-paying companies that can benefit from the powerful “spring and levers” effects described below. (As you read about these effects, keep Boeing (BA) and Caterpillar (CAT) in mind. They are good examples.)

Spring – Product demand

In a weak economy, businesses trim equipment purchases to conserve cash. However, a good part of the cutback is postponement – the purchases aren’t lost forever, merely delayed. This suspended buying (also called “pent-up demand”) accumulates, awaiting a better economy. Like a spring compressing, the longer the delay, the higher the bounce when companies resume buying.

For example, when air travel falls off, airlines postpone acquiring new planes or upgrading the old – they simply make do. That strategy works until air travel returns and competition heats up. Then, the race is on, with the airlines not only returning to their normal replacement strategies, but also making up for their delays.

Levers (AKA Leverage) Better than compound interest or buying on margin is the natural leverage that leading companies enjoy. It comes in three forms:

  1. Financial leverage – The use of non-equity financing (e.g., commercial paper, bonds and leasing) to “optimize” company earnings and the returns to shareholders. “Optimize” is the operative word, meaning the wise use of leverage that doesn’t put the firm at risk. Leading companies not only have sophisticated finance departments, they also have worldwide access to financial markets.
  2. Operating leverage – This can be a biggie, especially for manufacturing companies like Boeing and Caterpillar. Because production facilities have to be kept and maintained, even when sales drop, those costs are “fixed”. (On the other hand, costs that vary with sales, like materials used in a product, are “variable”.) This means earnings drop faster than sales in a slump because the fixed costs cannot be trimmed. Conversely, when sales rise, earnings climb faster.
  3. Pricing leverage – As we see everywhere, slow economic environments create discounts. This is no less true with big-ticket items like planes and machinery. The price reductions shrink as the economy strengthens, particularly as orders push production close to manufacturing capacity. Pricing leverage occurs because any discount reduction flows through as pure profit, so earnings can experience a sizable boost from just a moderate price adjustment.

So, Boeing and Caterpillar are good examples of the types of companies to benefit from the spring and levers effect as the economy improves.

Tomorrow, I will discuss two companies that have some different reasons for potential capital gains.

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John Tobey on Seeking Alpha

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February 2010