Are you hesitant to invest in stocks amid the ongoing financial instability and Federal Reserve's stimulus cut? Actually you should be, given the downtrend in major U.S. indices so far this year. You will, after all, be putting your hard-earned money at risk.
But you can turn the odds in your favor by applying the right stock-picking strategy. All you have to do is take advantage of the short-term turning points of stocks that have the capability of tiding over possible challenges.
Before I discuss the strategy and handpick potential winners, let us take a quick look at the stock market and its looming threats.
Is the Magnitude of Market Correction Reasonable?
It is believed that no clear direction of job data, barely increased manufacturing, uncertainty related to home and auto sales, and the latest upheaval in emerging countries have made the benchmark indexes lose strength. While these are no doubt enough to fade investors' bullish sentiment, the over-hyped magnitude of market correction is far more than what might be considered reasonable.
Actually, the economic data was not as strong as people expected based on last year's progress. So a reassessment of individual risk profile is keeping them away from the market for now.
Is Liquidity Management a Concern?
At least, the Fed's aggressive stance to reduce its stimulus signals a better overall economic picture. While this should translate into better investor sentiment, some negative factors cannot be ignored.
The reduction of money supply will enhance the buying power of each dollar and eventually translate into deflation. This will in turn have a reverse effect on economic growth with the flight of real interest rates. Further, failure on part of the economy to sustain the achieved growth level or the Fed in reaching growth targets will result in another liquidity crisis. And the outcome of a crisis is still fresh in our memories.
Otherwise, the U.S. economy should not suffer much, as the outflow of liquidity to emerging markets returns with increased demand for money as a result of the Fed's scaling back of stimulus. The withdrawal of capital to meet domestic demand has already started hindering growth in emerging markets.
On the other hand, the debt ceiling issue has resurfaced: the Treasury needs to raise the limit by the end of this month so as to forestall the risk of default.
The fate of the economy and the stock market is highly dependent on the Fed's successful liquidity management. If the stimulus is withdrawn before the economy effectively recovers, another crisis will be right around the corner. It all depends on the perspective of the new Fed chief Janet Yellen. She will perhaps tone down the aggressive stance given the lukewarm data. The semi-annual monetary policy will give a clearer understanding of her standpoint.
Meanwhile, the debt-ceiling standoff is expected to be another troublemaker.
So it's time to start making investment decisions considering the worst-case scenario. Keeping the likely negatives in mind, one should look for stocks that have the following features:
High Liquidity: This is the first thing to check, as companies that are quite capable of covering their short-term obligations will not falter even if the economy faces a liquidity shortage. So companies with a high current ratio should fare well, even if their profits get hurt.
Low Financial Leverage: Companies that depend less on external borrowings for capital expenditures should be safer choices, as the chance of a debt crunch cannot be ruled out. So you should narrow down your list by finding companies that have very small debt-to-equity ratios.
Ability to Utilize Equity and Assets: Highly liquid and low leveraged companies that can effectively utilize their assets and employed investor money to generate earnings should remain buoyant despite external financial threats. So you should add high return on assets (ROA) and return on equity (ROE) to your screening criteria.
Reinvestment Ability: Earnings power is another important measure in this strategy. Companies that are able to generate higher profits on each dollar of sale should have the flexibility to reinvest in their operations. So a healthy operating margin is necessary to reduce dependence on external borrowing.
Favorable Zacks Rank: Stocks that hold a Zacks Rank #1 (Strong Buy) or 2 (Buy) have witnessed solid positive earnings estimate revisions over the past few weeks. A favorable rank indicates that analysts are optimistic about the earnings picture of these companies despite potential challenges. This should finally help you to zero-in on the right stocks.
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3 Stocks Set to Gain Amid Liquidity Crunch
I ran a screen on Research Wizard with the following parameters:
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Current ratio greater than or equal to 3: This will select companies that are 3 times more capable to cover short-term obligations.
Debt-to-equity ratio less than or equal to 1%: This captures stocks that have a low degree of financial leverage.
ROA and ROE greater than or equal to 15%: This picks stocks that are generating over 15% earnings by utilizing their equity base and asset base separately.
Operating margin greater than or equal to 20%: This identifies stocks that have the flexibility to reinvest their pure profits, as their costs are under control.
Zacks Rank less than or equal to 2: This ascertains stocks that have been witnessing solid earnings estimate revisions and are poised to outperform. (See the performance of Zacks' portfolios and strategies here: About Zacks Performance).
Here are the top 3 among the 5 stocks that I could extract from the screen:
Alexion Pharmaceuticals, Inc. (ALXN): Headquartered in Cheshire, Connecticut, this Zacks Rank #1 biopharmaceutical company is my top pick.
Current ratio = 3.75
Debt-to-equity ratio = 0.03%
Trailing 12-month ROA = 18.47%
Trailing 12-month ROE = 24.25%
Operating margin (Trailing 12 months) = 35.32%
Skyworks Solutions Inc. (SWKS - Analyst Report): This provider of analog semiconductors is my second choice. The company is headquartered in Woburn, Massachusetts and currently carries a Zacks Rank #2.
Current ratio = 7.12
Debt-to-equity ratio = 0.02%
Trailing 12-month ROA = 16.15%
Trailing 12-month ROE = 17.88%
Operating margin (Trailing 12 months) = 20.16%
Oracle Corporation (ORCL - Analyst Report): This well-known database and application software maker is my third choice. This Redwood City, California-based tech database giant currently holds a Zacks Rank #2.
Current ratio = 3.38
Debt-to-equity ratio = 0.51%
Trailing 12-month ROA = 15.16%
Trailing 12-month ROE = 28.52%
Operating margin (Trailing 12 months) = 33.61%
Don't Miss Good Entry Points
None of my screening parameters is dependent on the price performance of these stocks. So you should add them to your watch list first and wait for good entry points, as these fundamentals will not change any time soon. In any case, these stocks will be better performers given their funding self sufficiency.
However, take action before these strengths are reflected in the stock prices. Don't wait too long!
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Disclosure: The author has no positions in any stocks mentioned.