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November 12, 2015

Idea Of The Week: Looking For Equity Ports In A Storm

by Steven Carroll.

While stock markets are inching higher, there are definite jitters about the sustainability of the rally and whether geopolitical factors in the Middle East or slowing growth in China may spoil the party. We thought we’d take a look at earnings quality as a proxy for companies likely to outperform in a growth-starved and potentially volatile market.

StarMine’s Earnings Quality model decomposes earnings into more and less sustainable components, rewarding companies whose growth is supported by high levels of cash flow and penalizing those where accrual accounting factors tend to have a disconcerting impact on overall EPS.

Raytheon Co. (RTN.N)

This well-known defense behemoth is likely to be a beneficiary of any market volatility, but defense stocks also tend to do well in any period of enhanced concern about geopolitical factors. Raytheon has an EQ score in the top 2% for North America, with particularly strong scores for cash flow. The strong score is a function of the company generating more free cash flow (cash flow from operations minus capital expenditures) than most other North American companies of its scale. Notice the above average cash from operations (above the industry median) as well as capital expenditures below the industry median, producing strong free cash flow relative to the industry (and the industry is no slouch).

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Source: Thomson Reuters Eikon

Firing on all cylinders

Profit margins and asset turnover also look great, with net operating asset turnover (scaled by net operating assets) also far above the industry median. The current share price implies 5.8% EPS growth over the next five years and the forward 12 month P/E is 16.8. Given trailing five- year EPS growth of 7.3% and the stock’s defensive characteristics, this looks like an interesting option for any spike in volatility.

Taser International Inc. (TASR.O)

Another defense stock, though this one is more familiar in the hands of police than the military. Taser also looks very attractive from an earnings quality standpoint, though you need to take a deep breath when you look at valuation – the current share price implies a 19.8% EPS CAGR over the next 10 years, compared to five-year historical growth of 9.8%.

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Source: Thomson Reuters Eikon

Also worth noting is that while EQ looks very attractive, the hedge fund community has taken a view on the likelihood of a misstep. The short interest score of 3 places the company in the bottom 3% – and the company scores poorly in terms of both relative and intrinsic valuation.

Markit Ltd. (MRKT.O)

A relative newcomer to NASDAQ, with the data giant having listed in mid-2014. The company is best known for its aggregated content in the credit space, as well as its strong market share in trade processing.

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Source: Thomson Reuters Eikon

Quality rises

Markit continues to show modest growth and is trading at a small premium to its own valuation history (F12M of 19.3 compared to a two=year median of 18.0). Given the number of crowded trades in the defensive space (Coke and Chipotle, anyone?) this seems like a fair price to pay for a robust business that should handle any downtown with aplomb.

While no two bouts of volatility are identical, it’s worth reviewing the StarMine documentation on the outperformance of earnings quality during 2008-9. If things do turn rough, this signal certainly helps identify those companies with strong business models, likely to emerge from a setback in good shape.

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