When there is the sort of stock market correction we recently saw on both sides of the pond, some share prices can change fast. The markets have partly recovered, but there is ongoing market turbulence that could potentially get worse before it gets better. I see that as an opportunity to hunt for shares to buy for my portfolio. But in doing so, I continue to pay close attention to three potential indicators of a share’s quality.
1. Business resistance to an economic downturn
There are few businesses that are unscathed when the economy suddenly takes a sharp downwards turn (though there are some).
But an economic downturn does not affect all companies equally.
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Whatever goes on in the market, demand for power distribution will remain. That does not mean a firm like National Grid will remain untouched. Market turbulence could drive up borrowing costs, for example. Given the company’s large debt pile, I see that as a risk.
But compare that to a homebuilder. When markets tank and the economy is seriously struggling, the commercial outlook for builders often plummets. It can take years for them to recover – and some never do.
2. Healthy balance sheet and manageable capital needs
Another quality indicator I consider is a company’s balance sheet.
Going into a difficult period, the more hard cash a company has the better, in my opinion.
Here I see a crucial distinction. Many companies talk about their ‘liquidity’, which is the amount of capital they have access to.
But if things go south and their lenders change their mind (or run out of money themselves), how useful is that liquidity? Being told you have a credit agreement of a certain size does not actually guarantee access to that money when the economy struggles and other borrowers are all scrambling for cash.
So when looking for shares to buy, I consider a company’s balance sheet but pay close attention to its cash and cash equivalents.
I also pay attention to its spending needs. Some businesses can cut back their spending requirements dramatically when the situation calls for it – but many cannot.
3. Pricing power
I also consider pricing power.
Here a cigarette company like Imperial Brands or British American Tobacco (LSE: BATS) is a good example.
Over time, cigarette sales look likely to decline and indeed I see that as a big risk for both companies. British American has made greater strides in developing its non-cigarette business but the economics of that remain far less attractive than cigarettes, for now.
But while cigarette sales are steadily declining, they have not collapsed. Recessions have come and gone, health risks have become far clearer, social acceptance of smoking has shrunk – yet large numbers of smokers remain tobacco addicts and will continue buying cigarettes even while manufacturers push through large price increases.
That already gives British American a lot of pricing power. It has even more pricing power than some rivals because it has developed a range of premium brands such as Lucky Strike that accordingly can achieve a premium selling price.
That explains why the company is a cash generation machine. Like US rival Altria, has raised its dividend per share annually for decades, through multiple economic storms and market crashes.
