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Focus on Organic Growth.
With Citi’s economic forecast calling for below-trend GDP growth (typically considered to be approximately 3% annualized) over the next year, we believe that investors will place a premium valuation on companies possessing the ability to increase their earnings at rates well in excess of the S&P 500, through organic (non-acquisitive) growth. Companies in the early stages of new product cycles or brand line extensions of popular products offer the best opportunities for organic growth and economic resilience, in our view.
Focus on Companies that Make Other Companies More Productive.
With productivity gains and resulting cost savings becoming more difficult to achieve given macroeconomic headwinds, we believe that companies will focus on those products and services offering a “value proposition” or enhanced return on investment (ROI). 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 deposits. Similarly, technology companies that offer products that make accessing data easier and more pleasurable are likely better able to withstand slowing demand, in our opinion.
Identify Long-Term Growth Trends.
Shifting demographic patterns or new legislation can often lead to critical behavioral changes that influence the products and services consumers and corporations purchase. Often, these trends are less affected by economic conditions because of necessity. In many cases, companies enjoying either critical mass or “first mover” status reap the benefits of these changes and develop strong customer loyalty, which, in turn, can lead to strong recurring revenues.
Maintain an Emphasis on Companies Possessing Financial Flexibility.
During periods of heightened uncertainty, access to new or additional capital might be more difficult to obtain. We believe companies that possess the financial strength to fund internal or external growth opportunities through strong and rising free cash flow(and low debt service costs) will tend to exhibit lower volatility and more stable returns. Metrics that take on added importance in the late stages of a credit cycle include: interest coverage, working capital efficiency, and free cash flow. We believe companies that possess low debt levels as a percentage of total capital will be rewarded by investors,particularly when access to financing is perceived as becoming more limited.
Make Sure “Perception” Can’t Become Reality – Avoid Companies That Need to Roll Debt or Access the Capital Markets During Adverse Conditions.
Recent market events show that a company that needs to raise capital or roll maturing debt can suffer severe consequences in the current market environment. What would normally be a regular occurrence has become a potential sign of weakness, given the extreme illiquidity in the market. Furthermore, share price weakness can raise questions about the perceived inability to raise capital and put a company into bankruptcy orconservatorship just as quickly as a lack of financing options can.
Pay Attention to the Quality of Earnings.
A good measure of a corporation’s quality of earnings is how closely its free cash flow (net income + depreciation and amortization +/- changes in working capital – capitalexpenditures) matches its net income. For a time, a corporation may be able to obscure an underlying deterioration in fundamentals through financial engineering. Generally Accepted Accounting Principles (GAAP) are based on accrual accounting and may allow for a higher degree of flexibility in recognizing revenues and expenses than free cash flow allows for.
Scrutinize Free Cash Flow.
We believe free cash flow is the clearest measure of a company’s financial flexibility. Companies generating excess free cash flow may choose to reward shareholders through the payment of a dividend or a share repurchase program. Other corporations maychoose to direct cash flow toward strategic acquisitions or internal growth opportunities. Investors should closely monitor corporations where 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.
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 estimaterevisions can provide investors with some insight into near-term operating momentum. Often, particularly during a period of slowing economic growth, the first earnings shortfall may act as a harbinger of future earnings disappointments.
Merger & Acquisition (M&A) Selection Criteria Shouldn’t BeDismissed.
While many investors believe a slowdown in M&A and leveraged buyout (LBO) activity could lead to a lower stock market valuation, we do not believe this implies an absenceof value. In our view, many of the same characteristics that financial buyers were drawn to over the past several years (strong free cash flow, low leverage, and solid profit margins) remain in place today, though in many cases at significantly lower valuations than last year. Screening for companies with free cash flow yields well in excess of prevailing bond yields can often be a starting place for attractive investment ideas.
Focus on the Long Term and KeepEmotions In Check.
Successfully negotiating difficult market environments requires a willingness to act quickly on investor misperceptions that frequently occur due to “panic-selling” or “group-think.” Emotionally charged markets are often driven by fear rather than thecareful analysis of fundamentals. In our view, a disciplined investment process, emphasizing strong or rising free cash flow, profit margin expansion, attractive valuation, positive changing internal dynamics, incremental market share opportunities, and strong management, can help maintain clarity in volatile markets.
Ten Rules of Thumb for a Volatile Market
Source: Citi Investment Research