Canada’s economy got through the economic maelstrom that hit the US and Europe bruised but not battered, but some simple top-down investing will help see you through the rest of the ride, notes Tom Slee of The Canada Report.

You can stop worrying about a double-dip recession. There is not going to be one, for the simple reason we were never in a recession.

Economists are coming to the conclusion that in 2008, we spiraled down into something far worse: a financial contraction. Harvard professor Kenneth Rogoff likens that to being initially diagnosed with flu and then discovering that you have pneumonia. It’s far more serious, the recovery period is much longer, and the after-effects are more prolonged.

At the risk of oversimplification, a recession is a periodic downturn in the economy when business activity slows, often as a result of bloated inventories. After a year, two at the most, demand picks up and growth resumes.

An economic contraction, on the other hand, is a major financial collapse caused by a huge overhang of debt and an imbalance of wealth and resources—something that we now have in spades.

There is little chance of a sustained recovery until the debt has been substantially reduced. And according to Dr. Sherry Cooper, chief economist at BMO Financial Group in Toronto, that is going to take another five painful years. It’s a grim prospect. A contraction stunts demand, output, and employment. There is no place to hide.

Does it really matter whether we are in a recession, depression, or contraction? Absolutely!

A financial contraction means that the usual recovery mechanism is broken. The American consumer, who generates 70% of GDP, is maxed out. Household debt more than doubled as a share of household income between 1982 and 2007, when the system collapsed. The spending spree has come to an end and the economy is likely to drift sideways for years.

Even when the consumer debt load has been paid down to manageable proportions, any recovery is going to be slow. So we have to adapt our long-term investment strategy to allow for a prolonged economic downturn. Things could get worse.

The US Commerce Department is revising its GDP growth figures downward. The American economy grew 0.4% in the second quarter, not 1.9% as first reported. Wells Fargo is predicting a paltry 1% growth in 2012.

How do we respond? To start with, plan to maintain a meaningful stock-market position, although you may want to reduce your present exposure.

A recent study by influential economist Donald Luskin at Trend Macrolytics showed that North American stocks produced a 12% return during post-World War II recessions. That is only slightly below the average returns in growth periods. In other words, despite the higher risk, equities tend to outperform other classes of investments during downturns and should not be entirely ignored.

That having been said, I think we have to modify our approach to stocks and allow for the fact that there is no rising tide. Look to the more defensive sectors. Historically, discount retailers, tobacco companies, and fast-food providers such as McDonalds (MCD) have performed well in bleak times. They are likely to do well again over the next few years.

At the same time, we have to adjust our investment criteria. My suggestion is that from now on we reduce our emphasis on earnings growth when assessing a company. Of course, earnings are going to remain important, but they are no longer the be-all and end-all. An ability to weather a prolonged deep recession is now equally important.

Billionaire value investor Warren Buffett loves to buy companies that show five consecutive years of revenue growth, and that has paid off. Now, though, I think we should consult Buffett’s mentor, Benjamin Graham, the father of modern financial analysis, for guidance.

Continued…

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In 1934, three years into the Great Depression and with no relief in sight, Ben Graham wrote his landmark book Security Analysis. He argued that the balance sheet was the measurement of stock’s true value.

Given that there are a lot of similarities between now and 1934, I think we should take a fresh look at his approach, especially with respect to book values and debt ratios. Then couple them to the earnings prospects when assessing a stock from now on.

A company’s book value per share is the difference between its assets and liabilities, in effect the shareholders’ equity, divided by the number of common shares outstanding. This number is readily available for all public companies.

The all-important price-to-book ratio is how much investors are willing to pay for this value. Ben Graham thought that people should never pay more than 1.5 times for book value in bad times.

In fact, these days investors often pay a lot more. For instance, Finning International (Toronto: FTT) was recently priced at $24, a little more than three times its $7.53 book value. Giant FMC Technologies (FTI) has been trading at a 6.8 price-to-book. That does not necessarily mean that either of the companies is overvalued.

However, those premiums do raise questions. My suggestion is that when you are weighing a stock, take a look at the price-to-book ratio and compare it to those for similar companies in the same industry.

To give you an example, most Canadian gas and electric utilities have a low price-to-book ratio of about 1.5. Northland Power (Toronto: NPI) is the odd man out at 2.6. That is not cause for alarm…but it’s worth monitoring.

An even more important analytical tool is a company’s debt-to-equity ratio. This measures the proportions of equity and debt a company is using to finance its assets. A company with $5 million of stock and surplus that owes $15 million has a debt-to-equity ratio of three. The higher the ratio, the greater the risk.

Well capitalized companies with a low ratio have little trouble servicing their debt, and are equipped to expand during difficult times through acquisitions. As a very rough rule of thumb, industrials should maintain a debt-to-equity ratio between 0.5 and 1.5.

As far as Canadian companies are concerned, a PriceWaterhouseCoopers review of debt levels showed that during recessions, debt loads in the forestry, industrials, and technology sectors tended to rise rapidly. On the other hand, energy and mines and minerals were inclined to maintain strong debt ratios. Of course, that is just a rough indicator. You have to look at stocks on an individual basis.

To give you some background, Loblaw (Toronto: L) has maintained a respectable debt-to-equity ratio between 1.0 and 1.3, its present level, over the last five years. CN Rail (CNI), one of my favorite companies, has a 0.5 ratio, while CPR (CP) is slightly below 1.0. Rogers Communications (RCI), as you might expect from the PriceWaterhouseCoopers findings, is higher at 2.6, but significantly down from a nail-biting 5.3 in 2004.

So that there is no misunderstanding, I am not proposing that you should go on a crash course in analysis. My point is that in a financial contraction we should look more closely at each company’s strength as well as its prospects.

A low price-to-book value and a debt-to-equity ratio of 1 or less would provide a good start. Those two simple tests may save you money and a lot of sleepless nights.

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