If history is a reliable guide to the future, McKinsey says corporate earnings in the US might fall by as much as 40 per cent from their 2007 levels, even though “few companies as yet anticipate such a blow to their earnings and general economic health”.

It bases this exceptionally bleak claim - contained in an article posted on its McKinsey Quarterly website - on an analysis of the historic relationship between corporate earnings and GDP, plus return on equity trends.

The consultancy provided some advice for executives to accompany its warning.

 It recommended:

• • looking at past downturns to see how things panned out and which approaches worked in the executive’s particular industry;
• • introducing more severe contingency plans for managing credit risk, freeing up cash, selling assets and reassessing growth;
• • considering countercyclical expansion (if the company’s balance sheet is strong enough) by hiring new staff, carrying out acquisitions etc;
• • sweet-talking investors in advance about any growth ideas that might be unconventional and require a dividend cut;
• • not dismissing out of hand the possibility of a partnership with sovereign wealth funds or private equity.

It concluded: “If the past is prologue, corporate earnings may face a more substantial and prolonged decline than the current consensus expects.”

This loosely ties in with a question I am planning to research in the coming days: how on earth can managers can make investment decisions when the pricing of assets and the prediction of future cash flows is so uncertain? I was talking to Anant Sundaram - a professor at the Tuck School of Business at Dartmouth specialising in finance - about this matter earlier today and hope to get some tips from him over the next fortnight or so. I’ll try to pick the brains of some other experts too. Please feel free to suggest particular questions that you’d like answered in the comment section below.

March 28th, 2008 in Capital allocation, Strategy | Permalink