The recent stock market crash has left a wide range of companies trading on low valuations. This situation is likely to increase opportunities for value investors.
However, the potential for future economic challenges means that identifying the best quality stocks could be more important now than it is during bullish market conditions.
Therefore, assessing a company’s balance sheet strength could be a worthwhile pursuit for long-term investors. Likewise, purchasing stocks that have solid track records of profitability in a range of market conditions could strengthen your portfolio’s return prospects.
Balance sheet strength
During a period of economic weakness, companies with strong balance sheets may have a greater chance of survival. For instance, they may have lower debt levels and a larger cash surplus than their peers.
This may mean that a temporary decline in their sales does not cause them to experience severe financial difficulty or bankruptcy. Instead, they could use their cash reserves to overcome difficult trading conditions.
Therefore, focusing on a company’s balance sheet strength could be an excellent starting point for investors. As Benjamin Graham once said, “Astute observers of corporate balance sheets are often the first to see business deterioration”.
Although low interest rates could support the economy’s outlook, many industries face a severe slowdown in demand for their products and services due to the impact of Covid-19. Buying businesses with solid balance sheets could reduce your portfolio’s overall risk and enhance its return prospects.
Competitive position
Tough operating conditions within an industry can strengthen the competitive position of dominant companies. They may, for example, have exposure to a wider range of markets and regions than their sector peers. Or, they could enjoy a larger degree of customer loyalty than their rivals.
These attributes could provide them with a wider economic moat. This may present itself in a more resilient financial performance during challenging economic periods, as well as higher returns in periods of growth.
Focusing on the strongest businesses in a given industry is a strategy employed by Berkshire Hathaway’s BRK.A BRK.B Warren Buffett (Trades, Portfolio), who once said to “Buy companies with strong histories of profitability and with a dominant business franchise”.
Companies with a solid track of successfully overcoming industry downturns may have a higher probability of doing likewise in the current economic climate. They may even be able to strengthen their market positions should weaker sector peers go out of business.
Insider purchases
Assessing the quality of a company’s management team can be a difficult task. However, determining their confidence in the business that they manage is an easier process. Investors can check the amount of stock in a company that is held by its management team, as well as whether they have been buying or selling shares recently.
According to Peter Lynch, insider purchases of stock can be a buying signal for investors. “Whether insiders are buying and whether the company itself is buying back its own shares. Both are positive signs”.
Given the low valuations present across many S&P 500 members at the moment, management teams that are confident in the financial position of their business may be more likely to increase their holdings. Likewise, companies with solid financial positions may be among the first to contemplate buying back their own shares while they offer wide margins of safety.
Insider sales of stock may be viewed as a red flag by long-term investors. By focusing on companies with management teams that have a positive view of their own prospects, and who reinforce that view through investing their own money in the business, you could improve your chances to unearth quality stocks in the current bear market.
Disclosure: The author has no position in any stocks mentioned.
Read more here:
- Successful Investing in a Bear Market
- 4 Tips From Peter Lynch to Help You Overcome Market Uncertainty
- Charlie Munger's Tips on Controlling Your Emotions in a Crisis
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