There are plenty of problems going on in the world right now. Inflation, higher interest rates, a war, and so on. It's not surprising that some investors may be worried about investing in ASX shares.
How are investors to know what to do?
For starters, it may be worthwhile remembering that the world has survived these sorts of things before. There was very strong inflation in the 1980s, with extremely high interest rates as well. A war regularly occurs somewhere in the world, sadly.
Higher interest rates and more costs can have an impact on how profitable a business is. So, let's learn some of the things to look out for from Motley Fool expert Scott Phillips, who was recently talking to NABTrade on a webinar.
Pricing power
How much control does a business have over its prices? Costs are only one side of the equation when it comes to generating profit. Phillips said:
Number one is simply, pricing power. Does your company have the ability to pass on any cost increases you may incur? if you're a miner — mining a global commodity like iron, or gold or coal or copper or something else — your ability to pass on those higher costs with higher prices is exactly zero.
Think about brands, think about contracts, think about businesses that are so institutionalised in terms of being inside a business — so a business-to-business software package, for example — very hard to change out if the price goes up. If they're a mission-critical piece of software, for example. So anything that locks you in, or gives you the ability to pass on prices.
… That allows you to make sure your margins don't get crushed with that higher inflation.
For example, ASX shares like Coles Group Ltd (ASX: COL), Telstra Corporation Ltd (ASX: TLS) and Xero Limited (ASX: XRO) have been increasing prices for customers.
Debt could be an issue
When interest rates were virtually zero, businesses were able to take on a lot of cheap debt, if they wanted to. But now interest rates have shot up, it's a very different picture for some ASX shares.
What was Phillip's view on debt? He said:
Be very careful of companies with significant levels of debt. Not because they're necessarily going to go broke, but because higher debt with higher interest costs, higher interest costs means lower profits. So even if you don't go broke with higher rates, your company profits can be materially impacted.
Businesses such as real estate investment trusts (REITs) and buy now, pay later are typically ones that have higher debt levels.
Capital needs
Some ASX shares are able to fund their growth organically. Whereas others may have needed to tap investors for more cash to accelerate their growth plans, or perhaps make an acquisition.
What's the expert view on this situation? Phillips said:
The last point is, think about capital. If you're a business that needs more money – think about small biotechs or technology businesses, miners – and you're hoping to raise more capital from the market. That's getting harder and harder to come by as rates go up.
Companies sometimes see their share prices fall in anticipation of a capital raising because investors can see that the business is going to need more cash, so those investors are looking for a discount. It might be fairly easy to work out which businesses are going to do a capital raising if they are burning through their cash pile.
Some ASX shares are now focusing on cash flow breakeven so they don't run out of cash and a capital raising isn't necessary.
Foolish takeaway
I think it's worthwhile that investors pay attention to Phillips' advice, to avoid some of the pitfalls of the current economic situation.
