Investing's Slash-and-Earn Theory

Companies that were quick to cut costs at the first hint of the downturn are likely to lead the pack when the economy rebounds

By Amy Tsao

Accounting-related worries continue to unsettle investors, but the good news is that most of the recent economic data indicate that 2002's highly anticipated economic recovery is on the way. "What's interesting is the breadth of statistics that are improving," says Russell Sheldon at Nesbitt Burns, the Bank of Montreal's equity subsidiary. As a result of the brightening picture, economists by and large are raising their expectations for growth in gross domestic product this year. The stock market should reflect the healthier economy.

Investors are betting they'll be seeing a modest improvement in capital spending and better earnings. But before you get too excited, don't forget that stocks might not get very far over the next several months because they rallied so exuberantly toward the end of 2001 -- with a rise of some 48% on the Nasdaq and 23% on the Dow from the lows following the terrorist attacks of September 11. "We're in transition right now," says Eric Leo, chief investment officer of Allied Investment Advisors. Further, most analysts expect the Enron fallout to nag at the market for many months to come.


  So how should investors approach the gyrating market? One tactic is to search out companies that were quick to cut expenses during the downturn. It was painful for those that started slashing at the first signs of a slowdown, and, at the time, many critics wondered if they were jumping the gun.

Now, amid a brutal environment for corporate profits, they'll likely to be the first to post better-than-expected earnings as the economy starts to pick up. Sheldon recommends buying shares in companies that have been "looking at taking full advantage of cost-cutting to get profit margins to rise."

It's not just stock prices that should get a nice pop: Over the long haul, companies' fundamentals generally improve as a result of their cutback efforts. Through layoffs, reductions in inventories, reining in capital spending, and shutting nonproductive plants and the like, many outfits are positioned to be more efficient and more competitive when the recovery does take hold. They're "very smart to get out ahead of this by taking the pain early," says Don Luskin of Trend Macrolytics. "They get ahead of the line when recovery happens."


  Look at General Motors (GM ). It recently surprised Wall Street by raising its earnings estimates and production schedules. GM has been getting leaner on the cost side for some time, so its bottom line should be hurt less than those of its rivals' by the zero-interest-rate deals of late 2001, which also lifted demand for cars. One of the company's most effective cost-cutting methods is reducing its materials costs. GM also is active in downsizing: In January, it announced plans to cut its workforce by 10% this year in North America and Europe. Analysts are excited about its stock prospects for this year.

Other cost-cutters with strong balance sheets and more mature markets for their goods or services are in line to make a comeback early in the recovery. The hospitality industry, which laid off massive numbers of people after September 11, should rebound as travel picks up again. Those likely to benefit should include hotels, restaurants, resorts, entertainment, and travel services.

Nat Paull, an analyst with New Amsterdam Partners, is buying Danaher (DHR ) and other diversified industrials. He figures that after being battered by the manufacturing recession, these companies will begin to see better earnings at the start of a recovery because they were closing plants, laying off employees, and working down inventories before most companies realized a slowdown was at hand.


  In the post-Enron era, companies are busily promising to make their financial statements easier to understand. But that will take time. Meanwhile, it's easy to identify companies that are cutting costs because they like to make sure Wall Street knows their focus is on the bottom line.

A record number of layoffs took place last year, says John Challenger, chief executive of outplacement firm Challenger, Gray & Christmas, which tracks layoff announcements. Many experts expect the layoffs to continue despite the improving economy, since companies are more worried about labor costs than the economy. They still have cost-cutting to carry out, Sheldon says.

Layoffs for January, 2002, the latest month for which data is available, were heaviest at auto makers, transportation, retail, and financial services, Challenger says. However, not every company that has been cutting costs will necessarily be a winner early in the recovery. Starting at the beginning of 2001, the heads began to roll at companies in the electronics, computers, telecom, and e-commerce sectors. Telecom companies were some of the biggest slashers, but that sector's problems run far too deep to be solved by cost-cutting alone.


  In many cases, the Great Paring Down of 2001 was motivated by a desire to survive rather than a simple drive to become stronger and more efficient. That's certainly still the case with telecoms. While their continuing cost-cutting efforts may stave off bankruptcy, earnings won't amount to much. Buying such stocks could be a high-risk bet as the recovery gains momentum.

Many tech companies will benefit from their expense-slashing efforts eventually, but it will take somewhat longer because demand for most technology products appears sated, says Phil Orlando, chief investment strategist at Value Line Asset Management. Keeping that in mind, though, the best strategy may be to search for outfits that were among the first to bring down costs. They'll be the ones most likely to deliver earnings surprises as the economy continues to improve.

Tsao covers financial markets for BusinessWeek Online in New York

Edited by Beth Belton

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