Finding Strong Stocks in a Sickly Market

Red ink is spurting everywhere. Here are five ways investors can find financially robust companies to ride out the current downturn

Every day seems to bring news of another company with shaky finances.

On July 15, it was General Motors (GM) trying to mend a broken balance sheet. The automaker is cutting costs and canceling its dividend as part of efforts to raise a much needed $15 billion.

And this is a particularly difficult time to be cash-hungry. A year into the credit crisis, lenders are reluctant to lend to anyone, whether a company or a home buyer, with a shaky credit profile.

In recent years, "it was pretty easy to get a loan," says Sam Stewart, chief executive and chief investment officer of Wasatch Advisors. That's changed. "If you're dependent on outside financing, you've got to review the playbook," he says.

BusinessWeek asked investing experts for tips on how to avoid stocks with weak finances, and how to choose strong companies at a time when strength seems especially valuable.

1. Look for lots of cash and low levels of debt.There are different ways to crunch the numbers, but expert investors agree on the importance of diving into the data. Look at how much debt is on the balance sheet, with short-term debt the riskiest. Look at how much cash the firm has. Compare cash and debt levels to rivals in the same industry. Another key measure many investors use is free cash flow, a determination of, when all is added up, whether more money is flowing into the firm than out in a given quarter.

Companies with little debt and lots of cash have big advantages in an environment like this.

"When they hit hard times, they have cash to tide them over," says Scott Armiger of Christiana Bank & Trust. He points to USG (USG), a building materials company hurt by the housing slowdown (, 6/18/08) but still modernizing its factories.

A healthy balance sheet also allows firms to make acquisitions when market valuations are low. "Strenuous times [are] when they go shopping, because they see businesses on sale," Armiger says.

Many weaker firms borrow heavily to finance acquisitions. "Debt can allow you to grow, but it can create a lot of problems in a downcycle," says Ken Hemauer, director of research at Baird Investment Management.

Companies can be crippled by high debt burdens. Rob Lutts of Cabot Money Management points to the debt-laden auto and airline industries. "If they didn't have the debt, they could adjust their business operations and succeed," he says. Exxon Mobil (XOM), however, manages to operate in a capital-intensive business with almost no debt, Lutts says.

2. Other financial measures.Cash and debt levels are at the top of most lists, but investors also include other criteria.

Lutts looks for "very high" aftertax profit margins, often of 25% to 30%. "It brings more strength to a company on a daily basis," Lutts says, citing Google (GOOG) and the Chinese firm New Oriental Education (EDU) as examples.

Mustafa Sagun, chief investment officer of Principal Global Investors' equities group, emphasizes not just good fundamentals, but improvements in those measures, such as increasing revenue, widening profit margins, and rising profits.

If a stock has a dividend, look at its history, Hemauer says. "It's not so much the [size of the dividend] as the consistency," he says. A dividend that is steady or rising is a great sign of financial strength, he says.

3. Sustainable advantages.Michael Yoshikami, president and chief investment strategist at YCMNET Advisors, looks for "companies that have staying power." He puts Walt Disney Co. (DIS) on his list of "industry-leading companies with sustainable competitive advantages."

Those advantages allow them to capture market share from their weaker competitors.

Another measure of sustainability is the ability to survive economic downturns, either through diversification or because of a business area insulated from trouble. Yoshikami cites Johnson & Johnson (JNJ), which reported better-than-expected earnings July 15 despite the tough economic times.

4. Check out the management team.Well-managed companies are still having difficulty these days if they're in tough industries like banking, notes Tim Speiss, a partner-in-charge of wealth-adviser practice at Eisner LLP. But the quality of management remains a crucial factor, he says.

Ron Sweet, vice-president of equity investments at USAA, suggests looking to see if, when management articulates a strategy, they stick with it. Also, when the business was doing well because of a good economy, did executives congratulate themselves? Or did they talk about preparing for the next downturn? The latter is an example of "a high-quality company," Sweet says.

5. Customer activity.Many businesses are only as strong as their customer base.

A company dependent on a small handful of customers is vulnerable if just one of them takes business elsewhere, Speiss says. A company that sells to the federal government might seem like a paragon of strength, but "what happens if the U.S. government cuts its budget?" he asks.

Another measure of customer strength is backlog. Lutts cites First Solar (FSLR), a solar-power firm with a backlog of orders that is 6.5 times this year's sales.

Many experts advise investors to ignore the headlines of the day when searching for strong companies. A nervous market may ignore evidence of long-term strength.

Hemauer says the weak market conditions are giving him a chance to "upgrade" portfolios into stronger, higher-quality names. The bear market can give his firm "an opportunity to make a move into a strong company that we have felt was too expensive" in the past.

The goal is to find stocks that are not only strong enough to survive the current downturn, but to take advantage of the next recovery whenever it finally arrives.

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