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Assessing Quality in Equities

6 April 2020Equities

3 criteria to evaluate "high quality firms":

  • How much cash firms held entering 2020 as a share of 2019 revenue – The higher the number, the better able a firm is likely to be able withstand revenue shocks, thus preventing cuts to dividends, capital expenditure etc.
  • Operating profit margin – A firm with a wider profit margin could be better positioned to withstand costly supply chain disruptions and potentially strong pricing power in their respective industries.
  • Leverage (net debt over equity) – Firms with lower leverage tend to have a lower risk of bankruptcy.
  • Screening for this criteria, Citi analysts find the basket is skewed towards sectors less impacted by the health crisis like IT, Health Care and Communication Services. These group may continue to outperform throughout the downturn, as earnings are likely to be much less impacted than more consumer-oriented sectors.

Assessing Quality in Equities

Past performance does not guarantee future results, real results may fluctuate.

Implications for portfolios:

  • Companies with high quality balance sheets tend to skew towards "growth" over "value", favoring IT, Health Care and Communications Services over Energy and Industrials. Firms in developed market economies also tend to be of higher quality, with more established businesses and superior corporate governance than found in most emerging markets. Lastly, high quality companies also tend to be larger. Small caps are more likely to be loss-making, have higher leverage than bigger firms and have low levels of cash on hand.
  • While most hard-hit segments of the market could have greater eventual "bounce-back potential", as the global economic contraction plays out in coming months, Citi analysts believe it is important to keep equity portfolios "healthy" with allocations to high quality, cash-rich firms.

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