The current bull market – at 10 years and counting – is the longest in the nation’s history. But instead of celebrating that longevity, plenty of people are worried about how much longer the good times can last, and whether we could be headed for a recession.
What does that mean for investors fretting that the next bear market will devastate their investment portfolios?
For one thing, those investors might want to ask themselves whether the stocks they are invested in are cyclical or non-cyclical, says Dr. Joseph Belmonte, an investment strategist and author of Buffett and Beyond: Uncovering the Secret Ratio for Superior Stock Selection (www.buffettandbeyond.com).
The answer could be critical, he says, because cyclical stocks perform well when the economy is humming along, but struggle when things turn sour. That’s largely because cyclical stocks are companies that provide something that’s not essential to daily living or that consumers can at least postpone purchasing.
“Sometimes a cyclical stock will begin to decline nine months before the market begins to weaken because of a pending recession,” Dr. Belmonte says.
Examples are stocks for companies such as car manufacturers, higher-end retail stores, and mortgage companies. Specific examples are Ford, General Motors, Caterpillar and Macy's.
Non-cyclical stocks, on the other hand, are the stores or companies people flock to for bargains when times grow tough. Some of these stocks are Dollar Tree, Costco and Ross Stores.
But for investors, just knowing the answer to the cyclical, non-cyclical question is not enough, Dr. Belmonte says. They still need to review a company’s numbers.
“If properly used, the numbers will tell us almost everything we need to know about a company,” he says. “If we use the correct numbers in the correct way, the bottom-line results will tell us which companies we want in our portfolio.”
The problem, Dr. Belmonte says, is that most analysts and investors use the wrong numbers when trying to decide whether a stock is a good or not-so-good option.
A comparable method of measuring the efficiency of a company's operations. That’s why Dr. Belmonte is a proponent of what’s known as clean surplus accounting. He says the most prominent investor who uses this method is Warren Buffett. Here’s a quick overview of how clean surplus accounting works:
- Traditional accounting determines the return on equity (ROE) by using earnings from the income statement divided by the book value (owners’ equity) from the accounting balance sheet. “This is not a good measure of comparing one company to another because that’s not what it was meant to do,” Dr. Belmonte says.
- Clean surplus instead uses net income from operations as the “return” portion of the ROE. It then constructs its own “owners’ equity” as the “equity” portion of ROE. The return on equity, as configured by clean surplus accounting, is truly a comparable method of measuring the efficiency of a company's operations, Dr. Belmonte says.
- Net income minus dividends, of course, will net a different owners’ equity than will earnings minus dividends. It is this new calculation of owners’ equity (net income minus dividends) that allows a truly comparable return-on-equity ratio to be developed. And it is this comparable ROE ratio that is the foundation of the success of clean surplus, Dr. Belmonte says.
With a potential recession looming on the horizon, Dr. Belmonte says, it’s vital that you review your portfolio, examine whether you have cyclical or non-cyclical stocks, and then put those companies to the clean surplus accounting test.
About Dr. Joseph Belmonte
Dr. Joseph Belmonte, author of Buffett and Beyond: Uncovering the Secret Ratio for Superior Stock Selection (www.buffettandbeyond.com), is an investment strategist and stock market consultant. He is fond of saying, “If you want to live on the beach like Jimmy Buffett, you've got to learn how to invest like Warren Buffett.” Dr. Belmonte has developed hedged growth income strategies for family offices, and has lectured to numerous professional and investment groups throughout the country. His weekly video newsletter is sent to thousands of investors, money managers, and academics both nationally and internationally.
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