When markets are volatile, high-quality companies can help protect and grow portfolios.
To discover such businesses, managers should break down a company’s fundamentals into the following five categories, says Craig Jerusalim, portfolio manager, Canadian equities at CIBC Asset Management. He co-manages the Renaissance Diversified Income Fund.
High-quality businesses often achieve high margins over extended periods of time and this signals a sustainable competitive advantage, says Jerusalim. “If that advantage doesn’t exist, [a company’s] margins could deteriorate over time.”
Businesses should have low leverage since they then have flexibility. “If you don’t have debt, you can never be forced into making short-sighted decisions,” he adds. Instead, companies should be able to depend on their balance sheets while waiting to make strategic acquisitions when competitors are looking for buyers.
Looking for low variability means focusing on businesses that have predictable cash flows, says Jerusalim. You don’t want to lose sleep over investments in businesses that take risks.
To ensure management teams are effective, meet with executives regularly to go over their intentions and plans when targeting new investments. Jerusalim favours teams that have track records of under promising and outperforming.
5. Company growth
It’s a deal breaker, he adds, “if a company can’t show growth and earnings, and free cash flow.” Without all three, a business risks falling into the value-trap category. So even if a company seems like a good bet after going through the first four steps, Jerusalim won’t invest unless its predicted growth and current price are reasonable.
Once he finds a company that passes his five-step test, he sticks to a buy-and-hold strategy. By doing so, he says you allow your investments to grow as companies expand and become more competitive. You’re looking for businesses to “outperform the market over the course of the investment cycle.”
And avoid random gyrations of the market, he adds, since it can be time-consuming to monitor how macro issues may impact companies. Jerusalim prefers to “spend the majority of [his] time identifying high-quality companies and really understanding their competitive advantages and catalysts for success.”
Also, good companies don’t fall in and out of favour often. If you stick to your core group of holdings rather than trying to read markets, he says, you have a better chance of outperforming even when markets wobble.
While there has been a focus on yield, he finds it’s only one component of a company’s total return. “More important than the absolute level of a company’s yield is its ability to grow earnings and cash flow and, ultimately, its dividend over time.”
A company may be able to reinvest its earnings back into its business to earn returns greater than the yield on its stock. “[But] if its prospects are limited, I would expect the majority of its access cash to be returned to shareholders,” says Jerusalim.