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Looking for clues in past downturns


IT is a forgone conclusion that we are entering a period of economic slowdown. Or perhaps, the signs have been there for some months but people are now finally choosing not to be in denial.

For five straight years between 2003 and 2007, companies in Singapore have been registering robust growth in revenues and earnings. The past few years can almost be described as a golden era for corporates where demand for their products was strong and costs were low, be it financing costs, or raw materials costs or even staff costs.

This has led to soaring profits. But things took an about-turn in the last 12 months. Oil and other raw material prices shot through the roof. The economic outlook is now very uncertain with companies not creating as many jobs. Against that backdrop, consumers have turned cautious and are tightening their belts. Consequently, demand has softened. So companies are hit on both ends, weaker demand and higher costs.

In the current environment, it is inevitable that earnings will decline. But by how much?

I thought it would be illuminating if we could go back to the last two downturns we’ve gone through and see what kind of impact the economic slowdown had on corporate earnings.

I used the Straits Times Index component stocks, since they are fairly representative of the economy. And I only used companies which have operating records going as far back as 1995. There were 18 of them and their financial records were downloaded from Bloomberg.

They are: City Developments, Cosco Corp, DBS Group, Fraser & Neave, Genting International, Hongkong Land, Jardine Cycle and Carriage, Jardine Strategic, Keppel Corp, Keppel Land, Noble Group, NOL, OCBC Bank, Singapore Airlines, SembCorp Marine, Singapore Press Holdings, SingTel and United Overseas Bank.

Back in 1995, the 18 companies had a combined revenue of $38.2 billion. Operating profit and net profit came to $8.2 billion and $6.4 billion respectively. As at 2007, the corresponding numbers were $143.8 billion, $20.6 billion and $22.2 billion.

During the past 12 years, revenue had grown by a compounded rate of 11.7 per cent a year, while profits grew by 11 per cent a year.

The year 1996 continued to be a good one, and the aggregate revenue rose 12 per cent while net earnings climbed 19 per cent.

Then came 1997, the second half of which marked the start of the Asian financial crisis. By the end of that year, the combined net profit of the 18 companies had fallen by 18 per cent. There was however still growth in the top line, with revenue expanding by 9 per cent.

The Asian crisis played itself out, and while it did, people were getting gloomier. By the end of 1998, net earnings fell a whopping 39 per cent. Still, revenue managed to edge up by 4 per cent.

Exactly a year after the Asian crisis started, the economies in the region staged a strong rebound – helped in no small part by the Internet boom that was taking place in the US.

The despair a year ago was replaced by euphoria by end of 1999. And for that year, the 18 companies’ net earnings more than doubled from the year before. In other words, the profit decline of the two prior years had been clawed back, and the aggregate profits of $8.3 billion in 1999 was about 8 per cent higher than the $7.7 billion chalked up in 1996.

The good times carried on until 2000, even though the air was slowly being let out of the Internet or dotcom bubble by early 2000.

And to make matters worse, US came under terrorist attacks in 2001 and the world became a much darker place. In 2001, the aggregate net earnings plunged by 36 per cent, and the following year, by another 12 per cent.

But just like the Asian crisis a four years earlier, when the recovery came, earnings came roaring back. In 2003, earnings surged 96 per cent and the following year, by another 76 per cent.

Net earnings growth in the subsequent three years were not as dramatic, although those years saw an acceleration of revenue growth.

Chart 1 shows the changes in the companies’ revenues, operating and net profits over the past 12 years, juxtaposed against the SES All Shares Index as at the end of the year.

Chart 2 shows the earnings per share (EPS) numbers. From there, you can see that the Asian crisis had a far bigger impact on companies’ EPS than the 2001-2 slowdown. The aggregate EPS of the 18 companies plunged to just $1 in 1998, from $5.5 in 1996. The decline was less severe in 2001 – it halved to $3 in 2001, from $6 in 2000.

Chart 3 shows how cash flow from operations compared with net earnings over the years. Up till 2003 – with the exception of 2001 – cash flow from operations had consistently exceeded the net earnings numbers. That’s probably because companies had to charge depreciations – a non-cash item – in calculating their net earnings. Since 2004, however, the net profit figures have consistently been higher than the cash flow from operations numbers.

It could be that the profits came from non-cash items like revaluation of certain assets, or the companies actually disposed of some of their assets at a profit. These disposals were one-off events and not part of the companies’ normal operations.

So as can be seen, in the previous two cycles, earnings decline span over two years.

The two-year earnings decline duration confirmed the finding of an analysis by Citigroup’s global strategy team.

The analysts studied MSCI Global Earnings Index over the last 35 years. They found that earnings weakness takes place over extended periods of time. They are not normally a one or two quarter event. They have averaged just over two years, they said. ‘The longest, in the early 1990s, lasted nearly four years. The shortest decline was in the late 1990s, but that still took over a year.

‘With earnings having peaked at the end of November 2007 the current period of weakness would look to have only just started if history is any guide,’ they said in a report in early June.

And on average, the peak to trough decline is 25 per cent. The two most severe declines were in early 1990s and early 2000s. Earnings fell by over 35 per cent. While the former was over an extended time frame, the latter, the most severe decline of them all, was of relatively short duration, they noted.

The Citigroup analysts said that historically, earnings have peaked well after the economic cycle and have not troughed until the economy is into recovery mode.

But for the current cycle, the peak in earnings occurred much earlier, in fact even before the global economy has really started to slow.

This is because the massive writedowns that have led to a collapse in the financial sector’s earnings have been brought about largely by non-cyclical factors, principally financial engineering and leverage, so the normal lagged relationship has not applied this time, they said.

Sector-wise, not all experienced earnings declines during periods of global weakness. Defensive sectors continued to see growth regardless of the harshness of the economic downturn, they said. ‘Utilities and health care sector earnings have always risen. Consumer staples earnings fell only once. Cyclical sectors have borne the brunt of declines. The commodity sectors have been particularly weak. Energy’s average decline has been 30 per cent and Materials 35 per cent. ‘Elsewhere amongst the cyclicals, declines have averaged around 20 per cent.’

So based on past cycles, global corporate earnings could fall anywhere between 10 per cent and 40 per cent going forward. The average has been 25 per cent.

Another approach is to look at the likely impact if return on equity (ROE) were to return to long-term average levels or collapse to previous trough levels.

Global ROE hit 35-year highs (16.1 per cent) last summer, driven by leverage in the financials sector, record profit margins, a shrinking equity base and an extremely robust global economy.

Despite falling since then, it still remains at historically elevated levels. Reverting the ROE to its 10-, 20- and 30-year averages, which range between 11.8 per cent and 12.6 per cent, would result in earnings declines of 22-27 per cent from last November’s peak.

But ROEs usually fall below averages, said the Citigroup analysts. If they fall to previous troughs, which have been between 8 per cent and 11 per cent, earnings would decline anywhere between 30 per cent and 50 per cent, averaging just over 40 per cent. ‘On this basis, the risks to earnings remain substantial,’ they said.

But in the report, Citi said it was of the opinion that the current earnings downturn could turn out to be a relatively mild one. ‘How could we be wrong?,’ the analysts asked. ‘There are some obvious reasons,’ they said. These include a more severe and extended economic slowdown, with emerging economy resilience proving temporary, a collapse in commodity prices, stronger-than-expected cost pressures and the credit crunch evolving into a more systemic financial crisis.

Are there already signs that some of the scenarios mentioned are starting to emerge? Perhaps, hence investors definitely have to be vigilant.

The worst, it seems, may not be over yet.

The writer is a CFA charterholder. She can be reached at [email protected]


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Wednesday 20th of August 2008

I have a list of banks that may fail and go bankrupt.

You can view it at my blog.

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