Through the Cycle: How to Identify the Best C&I Lending Opportunities in Challenging Times [RMA Journal, The]

Markets can remain irrational longer than you can remain solvent.

John Maynard Keynes, British economist (1883-1946)

As of this writing in early September, there is no beacon to light a clear course through stormy economic seas. The financial markets continue to ebb and flow on the unpredictable tides of good and bad economic news. Consumer confidence remains weak and fragile. Households are tightening their belts and working off their heavy debts

Keynes's "paradox of thrift" warns us that starving this financial fever may just leave us all dead from hunger. Still, it is not bad news, just a necessary adjustment to the overleveraged spending spree that was a key factor in the euphoric run-up of household debt, a harbinger of the Great Recession (Figure 1).

Business investment and private-sector job creation, both necessary catalysts for a solid, sustainable recovery, seem trapped in a maelstrom of uncertainty despite generally strong profits and a corporate America awash in cash. Profits have been robust, while the national unemployment rate remains stubbornly high (Figure 2). The unemployment numbers (14 million) underestimate the underemployed (8.8 million part-time workers seeking full-time work) and discouraged workers (those who have dropped out of the labor market, probably another 6 or 7 million people).

Unlike the fiscal stimulus provided by the American Recovery and Reinvestment Act of 2009 (ARRA), federal, state, and local governments are facing the prospects of unprecedented austerity as the debate to contain growth of public debt has taken center stage (Figure 3).

President Obama's recent job creation initiative is a step in the right direction, albeit a small one given the dearth of fiscal ammunition the administration needs to prime its governmental guns. To be sure, traction will clearly have to come from the private sector as U.S. policy makers have yet to find the Holy Grail that will pull the U.S. out of the malaise.

Compounding jitters are problems brewing overseas, including China's fight to control inflation and the European Union's struggle to contain the region's sovereign debt crisis.

According to September's National Association of Business Economists survey, GDP growth this year will be a paltry 1.7% and will then accelerate slightly to 2.3% in 2012. These forecasts are down 1% from the May survey. Unquestionably, the likelihood of a deleterious double-dip recession has increased.

So... Where Do We Go from Here?

An article in the December 2009-January 2010 RMA Journal1 offered some suggestions for finding solid C&I lending opportunities, which may be worth rereading since much of that analysis remains relevant. As underscored above, however, the economic landscape has changed dramatically and several of IBISWorld's banking clients recommended that we revisit the topic.

Obviously, this article can't possibly delineate all of the lending opportunities or risks. Nonetheless, its aim is to provide some insights and, in particular, offer a methodology for seeking sensible opportunities. Our criteria will identify sectors that:

* Are in the growth phase of their industry life cycle and are well positioned to take advantage of a sustained, if not spotty, economic rebound.

* Do not present inordinate risks should a double-dip recession or shallow growth path result.

* Are not excessively volatile.

* Possess some attractive attributes regarding the level of competition and barriers to entry (based on the work of Anita McGahan and Michael Porter2).

* Are capital-intensive, implying a large borrowing capacity.

* Can be potentially targeted as small business or mid-market clients.

* Have strong growth potential over the next five years.

Not an easy task indeed! But we believe we have a strong algorithm that takes advantage of the winds of change to clear the fog.

What Can We Learn from History and the Recent Cycle?

Although each cycle has its own unique characteristics, a long-term analysis of past economic recoveries reveals a concrete starting point.

Using real value-added3 data at the two-digit NAICS (North American Industry Classification System) level from the Bureau of Economic Analysis and the timing of recession troughs as defined by the National Bureau of Economic Research, IBISWorld examined the last 10 recoveries going back to 1950 (Great Recession data was excluded). The research measured sectoral growth and its volatility versus that of GDP. Table 1 combines this data with figures from the 2008-09 recession and 2010, the year of recovery.

Below is a selected summary of Table 1. The next section drills down to a more granular five-digit level.

* Agriculture and mining: We decided to group these together since commodity prices can be highly correlated (see our July-August 2011 Journal article on oil prices4). These highly volatile industries expanded rapidly during the Great Recession, riding the wave of buoyant prices bucking historical trends, until the "destructive demand" factor kicked in. To quote our July piece: "Higher (commodity) prices undermine demand in a weakened economy, trimming the sails of hyped-up energy (commodity) prices." There are nonetheless a myriad of lending opportunities that we'll address.

* Utilities: This relatively low-risk, low-variance sector seems to run in tandem with general economic performance. It does not lead or lag.

* Construction: This sector is, in a word, horrible. Residential housing remains in the doldrums and the commercial real estate market is weak. Public works spending, the centerpiece of the ARRA, seems doubtful in the near future given the burden of government debt.

* Manufacturing: This sector typically outperforms other industry segments in recovery years and 2010 was no exception, growing 5.8% compared with a 2.9% climb in GDP. Durable goods production was up nearly 10%.

* Trade: Historically, both wholesale and retail trade rebound sharply during recoveries. However, there are many caveats on the retail side given broad, powerful structural changes. Inroads made by warehouse clubs and super-centers, together with consumers' growing preference for buying online, have cut so deeply into traditional retail shopping that many of these retailers, sturdy 10 to 15 years ago, are barely surviving today.

* Transportation and warehousing: This highly procyclical sector tracks GDP very closely and is therefore vulnerable to downside risks. In fact, this group declined a whopping 12.2% during 2008-09. Air transportation fell 12.5% during the two-year recessionary period, while rail went off the tracks even farther, dropping more than 16%. Warehousing and storage fell "only" 6.6%, possibly on the need to find space for unsold inventories.

* Information: This industry has been dominated by rapid structural and technological change. It's populated by industries in the growth phase of their life cycles (software publishing) as well as those in serious declines (audio production studios). Hence, the analysis of aggregates simply dilutes the granular realities. The following section will help identify some key sweet spots.

* Finance and insurance: This sector is a laggard during economic recoveries. Although it actually expanded slightly during the recession, if we do the math for the 2007-09 period the group as a whole contracted. Hit especially hard were investment banks and related entities (NAICS 523)-think Lehman Brothers and WaMu-which contracted more than 30% in the three-year time frame.

* Professional, scientific, and technical services: This segment held up well during the recession, but experienced a tepid upturn in 2010. Nonetheless, we think there are positive points of interest, as will be articulated below.

* Administrative and waste management services: This sector contracted more than 10% during the recession, but seems to be on the uptick. Garbage in, garbage out, so this group emerges from recessions without much volatility.

* Educational and health care services: These services tend to be stable historically. However, government budget constraints, together with the cautious discretionary spending patterns of households, are complicating attempts to rank lending opportunities in these important areas.

* Arts, entertainment, and recreation and Accommodation and food services: These two industry sectors mirror GDP performance in recovery years, which doesn't augur well in an iffy economic climate. They declined precipitously during the Great Recession (9.4% and 14.6%, respectively).

Some Selected Opportunities

Agriculture and Forestry

Many banks have a long history of lending successfully to this sector, despite its volatility. Some notable areas going forward are shown in Table 2.

Soybean, oilseed, and corn farming may continue to benefit from government policies to support renewable energy sources. However, an article on alternative energy in the September 2011 Journal5 pointed out that biofuels are not cost effective without government support. Nonetheless, economic recovery will buttress farm prices. As for soybeans and corn, depleted stocks suggest firm prices through 2012, which could spill over to other basic commodities.

Generally, high capital requirements indicate a strong capacity to borrow further, enhancing the allure of this sector. Riding the wave of the trend to outsource, excellent opportunities can be found in agriculture and forestry support services in this capital-hungry group.

Energy and Utilities

An article in the July-August 2011 Journal6 addressed opportunities and risks associated with exposure to the natural gas supply chain. One bright area singled out was small-scale gas exploration and production, where lending would range between $5 million and $50 million.

To be sure, care must be taken when accessing plans in this arena. As the September Journal article points out, there is a clear disparity between firms that generate alternative energy and those that manufacture equipment. One case in point is solar power providers, an emerging industry that made our short list in Table 3. In contrast, solar panel producers face adverse competition from low-cost producers overseas, such as China. The recent bankruptcy of government-supported solar panel manufacturer Solyndra underscores this risk.

Construction

Despite record-low interest rates, housing remains in the doldrums and commercial real estate is a nonstarter at this juncture. As analyzed in a July 2011 IBISWorld special report,7 public works projects are likely to experience heavy cuts as the government retreats from the free-spending days of the ARRA.

For the longer term, we are more bullish on the residential side. Household formation, a leading driver of growth, is still robust. When the U.S. finally achieves sustained GDP growth and job creation, home builders and hired contractors will benefit, and there is a grand upside here as housing starts have been at dreadfully low levels for more than four years. The $64,000 question is when a revival will take place (Table 4).

Manufacturing

There are some gold nuggets in manufacturing and, hopefully, we hit some highlights in our December 2009 article, particularly in the areas of biotechnology and nanomaterials. A distilled version of our current research is found in Table 5.

We are cautiously optimistic for the mature auto industry given restructuring and pent-up demand. By August 2011, car sales were up 9.3% from a year earlier, spurred by a 15.5% jump in purchases of small vehicles. Growth for light trucks was in double digits as well. GM, Ford, and Chrysler all gained market share, mainly at the expense of Toyota and Honda. Despite the "cash for clunkers" tax break, the average age of cars on the road peaked in 2010 at 8.8 years. So as Americans retire their personal vehicles and replace their business fleets, mostly with small cars and light trucks, many banks' vehicle financing portfolios will put the pedal to the metal and enjoy some fast growth!

The Information Sector

What a morass! This broad sector is so diverse and is becoming so integrated with other business lines that the lines of NAICS definitions are blurring. Nevertheless, the sector's divergent prospects merit some attention.

Obviously, this sector is riding the roller coaster of the digital revolution. Traditional publishing is in decay, content industries are seeking new distribution channels, and technologically advanced companies are looking to further leverage their infrastructure to maximize returns. While print media get taken for a ride, information gatherers are finding other thrill-ride channels. Table 6 lists a selection of the few promising potential growth segments presenting low risk.

Business Services

The professional and business services sector usually plods along with relatively slow but stable growth. Many industries in this group are relatively secure and should do nicely even in a gradual recovery. Business outsourcing, as noted in our December 2009RMA Journal article, will support traditional opportunities including:

* Law firms.

* Accounting, tax, bookkeeping, and payroll services.

* Engineering services.

* Scientific research and development.

* Debt collection agencies.

* Security, burglar, and fire alarm services.

Another group of niche industries, listed in Table 7, is poised in a growth mode and providing safe, solid returns.

Education

We are very cold and introspective on education at the moment. According to IBISWorld's July special report, budget pressures threaten public schools, the testing and educational support services, colleges and universities, and a whole host of other education-related industries. On the other hand, one area that we are relatively sanguine on is trade and technical schools, which tend to be countercyclical.

Be alert, though, because the risk of lending to the once high-flying for-profit universities is expected to escalate (for more on this, see the IBISWorld article on for-profit universities in the November 2011 RMA Journal8). This industry has seen its reputation suffer as a result of controversial practices that accompanied its recent surge in growth.

For-profit universities, also called proprietary colleges, have a unique place in the education world. Unlike traditional public and private institutions, these schools are publicly traded. By investing a huge proportion of dollars into marketing, for-profit universities have attained massive enrollment rates. On the basis of revenue and enrollment numbers alone, the steady growth of these universities makes the industry enticing for lenders. However, even though their growth status allows them to rise above nonprofit schools in terms of profit and revenue, for-profit universities are coming under increased government regulation. So beware.

Health Care

Though typically considered a low-risk industry characterized by low unemployment and smooth growth, health care finds itself in the murky waters of low returns. Several factors present challenges, notably the relentlessly rising costs and lingering doubts over the course and effectiveness of the Obama administration's health care initiatives.

The jury is still out on how health care reform will affect Medicare and Medicaid. In the August 2011 issue of Commercial Insights,9 IBISWorld colleague Sophia Snyder identified the top 10 health care industries that garner the highest share of revenue from private insurance companies. Lending to these industries is a definite hedge against uncertainties in funding Medicare and Medicaid:

"... the Department of Health and Human Services (HHS) released health insurance exchange rules that will govern how states set up and run marketplaces where individuals and small businesses can shop for health insurance coverage. This new framework will impact several industries that derive a significant percentage of revenue from private insurance coverage. In the next five years, IBISWorld forecasts the top 10 industries to see additional growth in revenue and operating profit as a result of the new rules..." (see Table 8).

Despite the changing face of traditional health-care-related businesses, however, risks remain low. After all, no pain, no gain. Some of the juiciest areas are found in Table 9.

For more on this industry, see the additional articles on ambulatory care, senior care facilities, and hot start-up industries.10

Miscellaneous Opportunities

Finally, Table 10 presents a hodgepodge of other promising industries to be targeted.

Conclusion: It's the Best and the Worst of Times

When Charles Dickens wrote A Tale of Two Cities in 1859, his 60-year perspective on the French Revolution allowed him to see both the good and the bad in that historical event. Eighty years removed from the Great Depression and two years after the Great Recession, we have drawn on the records of those difficult times to find some potential bright spots in the current downward adjustment to economic growth.

Most of us thought we would be on a steady, albeit slow, recovery path by now. The first-half stall in growth is disconcerting, but corporate profits remain reasonably healthy and there is plenty of cash in the system. Instability in Europe is a mild contagion, but it's not a pandemic.

To be blunt, it's up to all of us in the private sector to lead the way, starting with smart lending. This article has identified roughly 80 industries here worthy of lender investigation, evaluation, and underwriting. Maybe we can learn from economic history and back some winners in this 80-horse recessionary race. v

For additional information, consider the RMA course Analyzing the Commercial Borrower's Industry, Market, and Competitive Risk.

Higher (commodity) prices undermine demand in a weakened economy, trimming the sails of hyped-up energy (commodity) prices.

Notes

1. Rick Buczynski, "Where Do We Go from Here?" The RMA Journal, December 2009-January 2010.

2. Anita McGahan and Michael Porter, "How Much Does Industry Matter, Really?" Strategic Management Journal 18 (1997).

3. Industry value added is also called industry gross product. In short, it describes the market value of goods and services produced by an industry minus the cost of goods and services used by the industry in the production process.

4. Rick Buczynski and Justin Molavi, "$150 Oil? What Would This Mean for Your Bank?" The RMA Journal, July-August 2011.

5. Justin Molavi and Deborah Stampli, "Alternative Energy: Government Incentives Ignite Growth," The RMA Journal, September 2011.

6. Justin Molavi and Rick Buczynski, "The U.S. Is Stepping on the Gas: Lending Opportunities in Natural Gas and Related Industries," The RMA Journal, July-August 2011.

7. IBISWorld Research Staff, "Top 25 Industries Negatively Affected by Federal Spending Cuts," IBISWorld Special Report, July 2011.

8. Kevin Culbert and Deborah Stampli, "The Risky Business of For-Profit Universities," The RMA Journal, November 2011.

9. Sophia Snyder, "Top 10 Industries to Benefit from Health Insurance Exchange Rules," Commercial Insights, American Bankers Association, August 2011.

10. Sophia Snyder and Deborah Stampli, "Ambulatory Care Offers Significant Opportunities for Lenders," The RMA Journal, June 2011; Mary Jo Taylor, "Lending to Senior Care Facilities," The RMA Journal, October 2011; and IBISWorld Research Staff, "5 Hot Start-Up Sectors," IBISWorld Special Report, September 2011.

Rick Buczynski, Ph.D., is a senior vice president and chief economist at IBISWorld. He thanks Dev Strischek of SunTrust Banks, Inc. for his continuing support and guidance. IBISWorld papers are available from Rick by request. He can be reached at [email protected].

Rick Buczynski, Ph.D., is a senior vice president and chief economist at IBISWorld, an industry intelligence firm.

(His article can be found on page 12)