Thought Leaders
Focus on Fundamentals: Finance and Investing in 2009
John Percival, academic director of Creating Value Through Financial Management, says managers and investors need to be prepared for a long downturn if past experience is any indication. He compares the current economic environment to when the bubble burst in Japan or the U.S. recession in the 1970s. In each case, it took more than a decade for the economy to recover.
“This could last for a long time,” Percival says. “Japan is not a perfect analogy but a fairly good one. It has taken them a decade to recover, and there is some question about whether they have fully recovered. That is particularly troublesome because it was somewhat specific to Japan – we had a strong economy in the U.S. and Europe – and in spite of that it took Japan a long time. We can’t assume that this will turn around quickly.”
There have always been economic downturns. When it is going on, it seems special and unique. It is not a real reason to change the way you manage your investments and the way you manage your company.
–John R. Percival, Adjunct Professor of Finance and Academic Director, Creating Value Through Financial Management
Boring is Better
Percival notes the current environment demonstrates the wisdom of building and investing in “boring” companies that are designed to create value in up times and down. Throughout the Creating Value Through Financial Management program, Percival refers to the company Emerson Process Management (formerly Emerson Electric). He readily admits that this is not a “sexy” company. “It is a boring company, not the kind of stock you’d call up your brother-in-law about,” he says. “But they not only do well in the good years; they also do well in the bad years. They have a whole management process designed for that outcome.”
In contrast, consider Washington Mutual, which a year or so ago was a hot company whose commercials compared its new approach to banking to the staid old traditional bankers. WaMu was placed into receivership by the FDIC in September and acquired by JPMorgan Chase. “Everyone fell in love with WaMu for a while,” Percival says. “Today, people think maybe stodgy banking and being somewhat selective about who you want as your customer is not so bad after all.”
The good news is that the same financial principles that should have applied in boom times hold true today. The bad news is that the fate of companies may have been sealed by past decisions. “How well you do in the bad years has precious little to do with what you are doing then,” Percival says. “How well you do in the bad years depends on what you do in good years to prepare for that.”
In fact, one of the things Percival has stressed in Creating Value Through Financial Management is that managers should be worried if they are doing well. “When you are doing well in a tough competitive global business, you know something special is going on. Competition shouldn’t be letting you do that. At the time you are doing well, you have to prepare for a change to take place. It is incredibly fragile. Companies that create value do not just do well in good years. Everyone does well in good years. Companies that create value are the ones that find ways to make money when things are tough. In good years, those companies look boring. In bad years, people look at those companies and think: They might have something here.”
Investors should also look at these “boring” companies as good long-term investments. “So many companies were stars and doing well for a while,” Percival says. “In the short run, people fell in love with them. Ten or 15 years later, the stars are not even around anymore.”
Investors and companies that have sufficient liquidity may find buying opportunities for stock or acquisitions in the current environment. “It is still a little frightening, even at these prices,” Percival says. “But you can buy a good company for a little bit of money if you have courage.”
Focus on Fundamentals
Fundamental principles of valuation and financial management continue to hold. “Nothing has changed in the way you value a company or shares of common stock in a company,” Percival says. “On the way up people throw out good fundamental valuation approaches, and it is human nature that we also throw out those principles and overreact on the way down. I don’t think anything has changed about the right way to value these companies.”
Over-optimism in rising markets translates into risk premiums and discount rates that are too low. Over-pessimism in down markets leads to risk premiums and discount rates that are too high. “There is always a happy medium. In this environment, we lose our focus on fundamentals, because the changes are more psychological than fundamental. It is unfortunate, for example, that we have to bail out people who did stupid things, but a panic could be devastating. The bailout may not be good economics, but it is good psychology.”
Cash is King
In this environment, cash is king. Companies with strong cash reserves are in a better position to weather an extended downturn. “It is somewhat ironic that when things were going well, companies that held on to large amounts of cash were pilloried,” Percival says. “It was not deemed good management and was seen as detrimental to investors to hold onto cash.”
In response to this criticism, companies with large cash reserves paid dividends, made investments, or bought back their own stock to reduce their cash holdings. GE, for example, initiated an aggressive share repurchase program. Over a period of years, it bought back $20 billion in stock. The company has now suspended its share repurchase program. “Companies that had opportunities to build up cash but caved into pressure to buy back stock now wish they hadn’t done that,” Percival says. “Now companies holding on to large amounts of cash are looking like geniuses.”
Without such advance planning, companies are in a difficult spot now. It is hard to borrow money. With share prices in the tank, issuing common stock is a losing proposition. “It is a little late now,” Percival says, “Companies now need to spend cash to get through this period, not foolishly, but in paying salaries and investing in R&D. It is too late to conserve cash now.”
Financial Knowledge for 2009
Whatever economic and political changes deliver in 2009, managers will need strong financial knowledge. Wharton offers a wide range of programs to build this knowledge — ranging from programs for managers new to finance to those for CFOs and other senior financial professionals. Finance and Accounting for the Non-Financial Manager, one of the longest-running Wharton finance programs, offers core financial knowledge. Drawing on finance and accounting faculty from Wharton’s top-ranked MBA program, this executive education program teaches how financial data is generated and reported, as well as how it is used for decision making, analysis, and valuation.
Creating Value Through Financial Management offers a more sophisticated exploration of issues such as capital structures, cost of capital, diversification, risk, capital budgeting, financial policy, the financial implications of non-financial decisions, and how to earn the minimum acceptable rate of return on an investment.
Other Wharton programs, such as Wealth Preservation in an Age of Uncertainty, provide investment knowledge to high-net-worth individuals and advisors. In an increasingly complex financial environment, these insights based on research and experience are more valuable than ever.
Don’t Panic
Above all, Percival stresses that managers and investors should keep a long-term perspective. “This too shall pass, although it doesn’t always seem that way while it is going on,” he says. “There have always been economic downturns. When it is going on, it seems special and unique. It hasn’t changed the fundamentals in the long run. There is usually some period of time until you get back to rationality. It is not a real reason to change the way you manage your investments and the way you manage your company.”
Your feedback is valuable to us. Please let us know if you consider this: