Timely tips for picking quality companies

When choosing investments, firms aim to pick companies that can weather economic storms and still come out winners. To that end, two firms recently highlighted the methods they use.

In a weekly market insights report, Richardson GMP says that while markets may be experiencing more volatility recently, they have a strong foundation. Rather than a market correction, the firm is more concerned about corporate debt going forward.

Why? Coming out of the Great Recession, firms expanded by making acquisitions, offering share buybacks or increasing dividends, says the report. Similar moves are being made now, with corporate debt ballooning to fund takeovers or return capital to shareholders.

However, raising debt to fund dividend increases and share buybacks is risky, says the report, noting that future stakeholders must bear the debt burden. Also, when it’s time to refinance debt, if the business hasn’t grown or interest rates have risen, the debt burden will be even larger than before, it adds.

Based on data showing the seven-year median change in debt-to-EBITDA for U.S. companies, the report says corporations have “gone on a debt-issuing binge. […] Almost every sector has expanded their debt leverage, some materially.”

If earnings power doesn’t keep up with increased debt, companies can expect future financial stress, the report suggests. While that risk isn’t imminent, the next bear market could hurt companies that haven’t been responsible with their balance sheets.

Taking a closer look at how much companies are leveraged has become a more prominent part of the firm’s analysis. Says the Richardson GMP report: “We are paying closer attention to credit spreads at this point of the cycle.”

Finding the best dividend-payers

In a rising-rate environment, dividend growers tend to hold up better than companies that have more static payouts, says Stephen Duench, vice-president and portfolio manager at Highstreet Asset Management, in an AGF blog post.

But how can you predict which companies will exhibit ongoing dividend growth as well as overall market performance? (Many investors rely too much on a company’s past history of payouts, says Duench.)

To make his picks, Duench describes AGF’s quantitative strategy, which ultimately results in a select list of uncorrelated factors being used to identify companies that are likely to perform well.

Those factors can vary greatly, he adds. For example, within Canadian cyclicals, factors include “capital expenditures as a percentage of depreciation expense” and “free cash flow interest coverage.”

The strategy highlights the advantages that an experienced quantitative manager has versus someone unable to examine stocks from an unbiased viewpoint, says Deunch in the blog post.

“That’s not to say our way guarantees a portfolio chock full of the best dividend growers out there,” he writes, “but we do expect an increased hit rate so that odds of getting the outcomes we seek are improved.”

Read the full report from Richardson GMP and the AGF blog post.