FEATURE | FALL 2010 EFFECT

Investing in the Recovery: Business

by Suzy Frisch

Many businesses spent the recession paring down costs, shrinking payroll, and finding ways to be more productive and efficient. These moves paid off in strong corporate balance sheets that are sending rising revenue directly to the bottom line. And now that we’re emerging from the Great Recession with numerous companies flush with cash, many believe it’s time to start investing in the recovery.

There are rich opportunities for businesses to capitalize on the turnabout in economic conditions and prime themselves for the future. Understandably, some business owners might be apprehensive about spending right now, but most economists and financial professionals think the worst is over.

“We’re still in the early stages of recovery, but there are increasing signs that the recovery is gaining strength,” says Arijit Dutta, a senior economist at Moody’s Analytics, Inc. in Westchester, Pennsylvania. “Now what’s needed … is hiring.”

It’s a cycle that feeds on itself: broad-based job growth gives consumers money to spend and cultivates consumer demand. More robust consumer spending then powers business growth, profit, hiring, and expansion. And that spells recovery.

David Vang, a professor and chair of the finance department at the University of St. Thomas in St. Paul, Minnesota, believes strongly in reversion to the mean—that the economy grows roughly 4–5 percent over a 100-year period. “We’ve had some tough years … but most likely it’s going to get better,” he says, adding that he believes the economy is in recovery mode.

Investing for growth

As the country transitions from recession to growth, businesses should prepare for both continued turbulence and an expanding economy. Vang offers three recommendations:

1. Pay down lines of credit. This is especially important so that businesses can stay flexible during rocky times. Interest rates are very low, so many business are tempted to use their credit. But Vang recommends tapping about 30 percent of available credit. Then when the recovery really takes off, businesses have the capacity—and the financing—to ramp up quickly to meet rising demand. LarsonAllen Financial’s Mike McConnell highlights the story of Best Buy versus Circuit City. Best Buy was the winner after Circuit City took on too much debt and failed in 2009. McConnell adds, “Businesses that are highly leveraged will be the first to fail if we don’t have a strong recovery in the economy.”
2. Invest in anything that will speed up the delivery of products or services to customers. That could include technology, equipment, or process improvements. “You want to deliver to customers as fast as possible so that they don’t change their minds and take their business to a competitor,” Vang says.
3. Consider any capital investment that might delay the need to hire more people. “There is a difference of opinion on how strong the recovery might be, and people are very expensive in terms of benefits and training,” notes Vang. “So anything that can make your current employees more productive and delay the hiring of the next person is absolutely necessary.”

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McConnell also advocates caution, questioning whether ripple effects from the recovery really have hit Main Street yet. In working with companies in the $5 million to $100 million revenue range, he observes that many clients’ revenue growth and orders are sporadic; they still don’t have much access to capital because banks are tight on lending.

“Businesses should build their balance sheets, which means getting lean, having plenty of cash reserves, and not overextending their credit,” McConnell says.

Options for investing

Companies that have been financially prudent and accrued healthy amounts of cash are itching to get some of it off the books. They have several smart choices for investing in the recovery. They might consider an acquisition, purchasing equipment or services, or paying out dividends to shareholders.

An acquisition could open access to new markets or gain synergies from joint operations. It can give a business more buying power and boost earnings per share, says Tony Hallada, principal-in-charge of LarsonAllen Financial in Minneapolis. There’s another reason acquisitions make sense: valuations. Multiples, or price-to-earnings ratios, for private businesses have dropped significantly from their pre-recession peak and are very reasonable.

“As far as prices are concerned, there has probably never been a better time to buy a private company in the last 10 years than right now.” Hallada adds, “And I think there will be many for sale as Baby Boomers retire.”

If companies don’t want to contend with buying another operation, McConnell recommends spending some cash on building market share and using that strength to operate more competitively. Vang says that with strong cash reserves and new vitality, businesses then play a waiting game until more leveraged competitors falter and fail. Then they can use their cash to swoop in and take over the competitor’s assets and/or customers.

When you have ample cash, another alternative is to pay back investors through dividends. That way, investors can take their funds and seek out other opportunities. More companies are paying dividends as part of a shift in economic thinking. Instead of having investors buy stock with the intention of making money by selling, they are craving a vehicle to capture regular returns on their equity, McConnell says. When a company pays out dividends it might attract new and steady investors seeking consistent income from their investments.

Lean and productive

Thanks to excess capacity in the economy, it’s not a great time to invest in most kinds of equipment, says Hallada. The exception is equipment that can boost a company’s productivity or systems. “The winners down the road will have great service and great product but also great productivity,” he adds.

Teaming up with a lean or continuous improvement consultant can help streamline operations and cut out operating waste. “There’s a big return on investment from bringing in a consultant to analyze operations, procedures, technology, and processes,” notes Hallada.

In addition to increasing productivity, investing in technology is also a strong bet because it allows companies to redirect employees to different positions or keep the workforce small and nimble, Hallada explains. Whether it’s installing a more efficient system for tracking inventory or transitioning to electronic order processing, technology can help businesses improve their competitive advantage.

Financial reform

Uncertainty still surrounds the financial industry. Financial reform will offer more consumer protection against abuse in the mortgage, auto, and credit card industries, but there will also be more oversight of financial instruments like derivatives, and the government may have the ability to liquidate financial firms that have grown “too big to fail.”

Many say it’s too early to tell how the reforms will affect business investments and personal finance, but one thing will probably hold true: at least for a time, businesses will have a hard time accessing capital. “Various aspects of the proposals might cut into the profits of banks so they will be more selective on where they will lend,” explains Vang. “To get credit, small businesses might need to pledge their personal assets as collateral, which is a scary thing to do.”

Hallada argues that regulation is needed because Congress repealed the Glass-Steagall Act in 1999, which had prevented commercial banks from owning other financial institutions like securities firms and investment banks. Abuses stemming from this repeal—including mortgage-backed securities, derivates, and credit default swaps that trampled the housing market—should be prevented by new oversight and a dividend exchange. However, there still will be creative investing products available for those willing to take the risk.

The financial reforms don’t go as far as some had feared, Hallada says, and overall, he professes to be an optimist about the economy. He believes the United States will make the right decisions to reduce its debt and put the country’s financial house in order. And that spells positive returns for business. As the economy continues to perk up, and businesses stabilize financially, management can take a bit of risk and once again pursue growth.

 

Tony Hallada and Mike McConnell are principals of LarsonAllen Financial, LLC, member FINRA & SIPC and are not affiliated with the author. One should not rely on this information for the primary basis of investment, tax, or financial planning. General market information does not take into account such factors as an individual’s goals, objectives, risk tolerance, tax situation, age, or time frame. We believe the information obtained from third-party sources to be reliable, but neither LarsonAllen Financial, LLC nor its affiliates guarantee its accuracy, timeliness, or completeness. The views, opinions, and estimates herein are subject to change without notice at any time in reaction to shifting market conditions. Tax laws change and investments in the stock market entail risk and potential loss of principal. Past performance is no guarantee of future results. This material may not be republished in any format without prior consent.