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‘Quality’ companies are getting stronger yet their shares are down in this selloff. This is how to find the bargains.

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If you’re a long-term investor, this year’s selloff is good news because it offers a great chance to pick up quality companies at a discount.

But wait a second. If a company is “high quality,” why would its stock be getting hit?

“Portfolio managers have been selling what they can as opposed to what they want to sell, and high quality has more liquidity,” says David Sekera, Morningstar Direct’s U.S. market strategist.

Now is the time to join the liquidity providers and buy the weakness in quality names getting dunked. You probably won’t catch the exact bottom — and if you do, it will be sheer luck. But quality companies should survive and thrive on the other side of the bear market.  

What exactly does “quality” mean? Here are definitions and examples from four money managers and strategists.

1. Solid cash flow and strong balance sheets

This is key, because it keeps a company from being beholden to banks, bond investors or the stock market to continue funding growth, says Chuck Severson, who manages the Baird Mid Cap Growth Fund
BMDIX,
-0.48%
.

“That is an advantage at times like this,” says Severson.

Companies with financial strength don’t have to stop doing research and development. They don’t have to stop opening stores.

“And they come out stronger because their competitors are facing difficult challenges,” says Severson. “These companies take share in this environment.”

Here’s another plus: During recessions, weaker companies trim work forces to maintain margins. So the stronger companies have an opportunity to pick up talent.

Severson is worth listening to, because his fund has beaten its Morningstar mid-cap growth category and index by one to two percentage points, annualized, over the past three to five years, according to Morningstar Direct.

Quality mid-cap companies are trading at attractive discounts right now, says Severson.

Here’s his logic. The group has declined about 30%. That’s in line with the typical 30% earnings decline in most recessions. But this recession — if we have one — might be milder.

Why? The economy is getting a boost from the decline of the coronavirus, as well as negative real interest rates and strong employment.

“It would be unlike any recession we ever had,” he says. “We will see earnings estimates come down pretty broadly. But I don’t think as broadly as stocks tell you. There are lots of our businesses I am happy to buy with a one-year time horizon. “

From his portfolio, consider Synopsys Inc.
SNPS,
-2.15%

and Cadence Design Systems Inc.
CDNS,
-2.57%
,
which offer automation software that engineers use to design and test chips. Their stocks are down a lot with the tech sector, but business performance has held up. Synopsys posted 25% revenue growth to $1.28 billion in the first quarter, and operating cash flow grew 29% to $905.7 million. The company expects 20% sales growth to produce $1.6 billion in operating cash flow this year. Cadence reported 22.5% first quarter revenue growth to $901.7 million. Operating cash flow grew 61.5% to $336.6 million. It expects 15% sales growth this year to $3.43 billion at the high end of guidance.

Argent Capital Management portfolio manager Kirk McDonald also puts cash flow on his short list of signs of quality at companies. He looks for companies that generate higher cash flow than peers. He also likes to see above-average profitability, high returns on assets, dividend or share buyback growth, and some change that might serve as a catalyst — such as a new management team or new products.

Here’s a company that checks enough of the boxes to qualify as a quality name: Cheniere Energy Inc.
LNG,
-1.65%
,
which exports liquid natural gas from the U.S. Cheniere has used its tremendous cash flow to buy back shares and boost dividends. The company will return $2 billion this year to shareholders via buybacks, says McDonald. It’s also using cash to pay down debt. Cheniere has been boosting its return on assets (ROA) every year since 2016. ROA was 8.2% last year compared to 3.5% in 2017. The big change in the mix here is the increased demand for U.S. LNG in Europe as the continent tries to wean itself off Russian supplies.

McDonald is worth listening to because, since its 2014 inception, Argent Capital Management posted 12.75% annualized returns compared to 11% for the Russell Mid Cap Index
RMCC,
-2.23%
,
through the end of March.

2. Businesses with wide moats

Protective moats help companies produce excess returns over the long term. Warren Buffett is a big fan of moats, which probably helps explain his success. These protective barriers are also a core part of the investment analysis at Morningstar.

Moats are created by strengths, such as powerful brands, proprietary technology, scale advantages from sheer size or network effects (more users make a service more valuable). Companies with moats “generate excess returns over the long term and they have the best ability to withstand economic disruptions,” says Sekera, the U.S. strategist at Morningstar.

In the current selloff, you can find an unusually large number of wide-moat companies with four- and five-star ratings (Morningstar’s highest). The list includes several that have “rarely ever traded at such large discounts to our intrinsic valuations,” says Sekera.

Here are three examples.

First, consider the chip-design company Nvidia Corp.
NVDA,
-2.43%
,
which creates high-performance graphics processing units used in gaming, data centers, artificial intelligence, computer-aided design, video editing and self-driving vehicles. Nvidia derives its moat from the R&D prowess powering its GPU technology.

“This is the first time since November 2012 that Nvidia is at a four-star rating,” says Sekera.

Next, consider the credit-ratings agencies S&P Global
SPGI,
-0.65%

and Moody’s
MCO,
-1.06%
.
These four-star-rated companies have economic moats because of their track records and reputation, and the regulatory challenges facing potential new competitors.

3. Pricing power

Pershing Square’s Bill Ackman says pricing power is a key characteristic that defines “quality” at companies. After all, if a company can raise prices without losing business, it’s a sign that customers really like what it does. That seems to be the case with Chipotle Mexican Grill Inc.
CMG,
-2.47%
,
Ackman’s second-largest position at Pershing Square (at 17% of the portfolio).

Chipotle raised prices by 4% in the first quarter. That helped power respectable 16% revenue growth to $2 billion, and an earnings beat. Despite the price hikes, comparable-restaurant sales went up 9%, which tells us customers were not fazed by the increases. (The rest came from new restaurant openings.) Higher prices helped operating margins rise slightly to 9.4% from 9.3%.

But for real inflation-beating price increases, consider another top holding of Severson at the Baird Mid Cap Growth Fund: Pool Corp.
POOL,
-2.02%
.
The world’s largest wholesale distributor of swimming-pool supplies, Pool raised prices 10%-12% in the first quarter, which helped drive sales gains of 33% to $1.4 billion. The company’s operating profit margin expanded 4.5 percentage points to 16.7%. Operating income rose 83% to $235.7 million.

Expect more of the same. The company raised its full-year earnings per share target to $19.09 from $17.94 at the high end of guidance. Pool is growing through acquisitions, but it also benefits from migration to Southern states where pools are more common than in the North.

Michael Brush is a columnist for MarketWatch. At the time of publication, he had no positions in any stocks mentioned in this column. Brush has suggested LNG, NVDA and CMG in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.

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