Citi gives 10 tips to spot investment-worthy companies

Citi private banking strategist Marshall Kaplan says one of the best things for investors to do is to keep their emotions in check.
Periods of market volatility can often be good times to invest in high quality companies at attractive prices, says US-based Marshall Kaplan, senior equity strategist for CitiÆs private client investment strategy group.

ôGiven the upheaval in the financial system and an uncertain macroeconomic environment, markets must be approached with caution,ö Kaplan says. ôStill, market volatility often creates opportunities in individual stocks. Citi believes that patient investors, those able and willing to ride out the near-term gyrations, could benefit from the current market turbulence by building positions in high-quality companies.ö

CitiÆs analysis suggests that expectations are still too optimistic. Forecasts have come down for this year but are still above CitiÆs projection of a nearly 9% decline, on average, for the companies in the Standard & PoorÆs 500. For next year, the StreetÆs consensus forecast calls for a 24.7% gain while CitiÆs estimate is just 2.6%.

The process of recalibrating earnings expectations has the potential to exacerbate an already volatile environment, says Kaplan. Longer term, however, Citi believes the equity markets are reasonably well-positioned to contend with these concerns.

Kaplan outlines ô10 rules of thumb for a volatile marketö, which he believes can help investors identify high quality companies.

First, focus on organic growth. With slow economic growth expected over the next year, Citi believes that investors will place a premium valuation on companies possessing the ability to increase their earnings through organic growth. In CitiÆs view, companies in the early stages of new product cycles or brand-line extensions of popular products offer the best opportunities. In this environment, such companies are better positioned than those buying their gains through acquisitions.

Second, find companies that make other companies productive. Companies are finding it harder to make productivity improvements and gain the resulting cost savings. That puts firms with products or services that allow their customers to be more productive in an attractive position. For example, oil service companies that possess the latest technologies can charge a premium price because they provide an efficient way to extract difficult-to-access oil and gas. Similarly, technology companies that make it easier to access data are better able to withstand slowing demand.

Third, identify long-term trends and those benefiting from them. Shifting demographic patterns or new legislation can often lead to critical behavioural changes that influence the products and services consumers and corporations purchase. Often, such trends are less affected by economic conditions. In many cases, companies enjoying either critical mass or ôfirst moverö status reap the benefits of these changes and develop strong customer loyalty, which, in turn, can lead to strong recurring revenues.

Fourth, emphasise companies with financial flexibility. During periods of market stress, getting access to new or additional capital might be difficult or even impossible. ThatÆs why Citi believes companies that possess the financial strength to self-finance their growth will tend to exhibit lower volatility and deliver more-stable returns. Key metrics to watch are the interest coverage ratio, which compares a companyÆs earnings before interest and taxes (EBIT) to the companyÆs interest expenses of the same period; working capital efficiency, or current assets minus current liabilities divided by sales; and free cash flow (see below). Citi also believe investors will reward companies that possess low debt levels as a percentage of total capital.

Fifth, avoid companies that need to access capital markets under duress. Recent events show that a company that needs to raise capital or roll maturing debt can suffer severe consequences. What would normally be a regular occurrence is now often viewed as a potential sign of weakness. Furthermore, share-price weakness may raise questions about the perceived inability to raise capital and can put a company into bankruptcy or conservatorship just as quickly as a lack of financing options.

Sixth, scrutinise free cash flow. Citi believes free cash flow is the clearest measure of a companyÆs financial flexibility. ThatÆs a metric that starts with net income, adds back depreciation and amortisation charges, adds or subtracts changes in working capital and deducts the level of capital expenditures needed to maintain the business. Companies generating excess free cash flow may choose to reward shareholders through dividends or share repurchases. Other corporations may choose to direct cash flow toward strategic acquisitions or internal growth. Investors should closely monitor corporations in which significant changes in depreciation schedules can have a meaningful impact on near-term earnings. Additionally, a large increase in receivables or inventories can be an indication of potential trouble ahead.

Seventh, assess the quality of earnings. For a time, a company may be able to obscure an underlying deterioration in fundamentals through financial engineering. However, to judge the quality of earnings, compare net income to free cash flow. If earnings look strong but the free cash flow does not, that could be a sign of poor earnings quality. This happens because Generally Accepted Accounting Principles (GAAP) is based on accrual accounting and may allow for a higher degree of flexibility in recognising revenues and expenses.

Eighth, avoid value traps. In our view, investors should focus on forward earnings projections because many economically sensitive companies, particularly at or near cyclical peaks, tend to appear attractively valued based on trailing earnings. A focus on consensus earnings estimate revisions can provide some insight into near-term operating momentum. Often, the first earnings shortfall may act as a harbinger of future earnings disappointments. A lower stock price does not necessarily indicate better value.

Ninth, think like an acquirer. Just because there is a slowdown in mergers and acquisitions or leveraged buyout activity does not mean there is an absence of value. In our view, many of the same characteristics that financial buyers were drawn to over the past several years û strong free cash flow, low leverage and solid profit margins û remain in place today, though in many cases, at significantly lower valuations. As a starter, look for companies with free cash flow yields well in excess of prevailing bond yields.

Tenth, look to the long-term and keep emotions in check. Negotiating difficult market environments requires a willingness to act quickly on misperceptions that frequently occur due to panic selling or ôgroup thinkö. Emotionally charged markets are often driven by fear rather than careful analysis of the underlying fundamentals. A disciplined investment process, emphasising strong or rising free cash flow, profit margin expansion, attractive valuation, positive changing internal dynamics, incremental market share opportunities and strong management can help investors maintain clarity in volatile markets.
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