Still opportunities to buy good stock

At first glance the market outlook may seem pretty bleak, but there are still good investment opportunities in sound companies with strong fundamentals for careful stockpickers.

The deteriorating operating environment for companies looks set to continue, as the credit crunch impacts on more industries and regions and the global economic slowdown gains traction.

More recently, a falling oil price has soothed investors’ concerns on inflation, but there are still too many uncertainties over the macro-environment for the market’s liking – and it looks as though high levels of volatility and subdued risk appetite will be with us for some time yet.

However, there are still opportunities at the stock level, especially in quality companies that are well-positioned to beat long-term market expectations. In particular, sustainable earnings growth stories make attractive investments: well-managed companies leading the market in their field; those operating in growing markets; and those growing their dividend – an important but often overlooked indicator of a company’s health.

It is also vital to consider valuations, which are largely being ignored in favour of short-term factors – this is ‘growth at a reasonable price’. Over time, these companies’ attributes should overshadow the more negative external environment and, as part of a diversified portfolio, contribute to a resilient fund performance.

Positive investment potential also exists among companies with strong balance sheets whose share prices have come under pressure because of indiscriminate negative sentiment, providing a buying opportunity. Many of these companies are quality cyclicals that have suffered from aggressive selling since the start of the credit crisis, the market having overlooked their fundamentals. The fact that the market has been too negative with many of these companies makes this a compelling investment area, although selectivity is key to good returns.

Keller, a ground-engineering specialist for example, has suffered as investors fretted over its exposure to American housing. However, the company has a strong order book across all regions and, while it generates half its earnings from America, only about 20% of that is from the residential sector. Most comes from the commercial and industrial sectors, which are likely to be more robust. It is a leader in its field, with good management and high barriers to entry. In addition, Keller’s management team is impressive and the company’s low level of gearing is encouraging.

Similarly, Carnival, a cruise ship operator, was sold down on concerns over the high oil price and the depth of consumers’ pockets. While oil is a big cost for the company, demand for cruise holidays will stay healthy, supported by demographic trends in many Western countries where a large percentage of the population is now over 50 – the target market for this type of holiday. In addition, the company can bring further portfolio diversification as it benefits from a falling oil price.

One area to avoid an overweight in, however, is banks. Much more deleveraging needs to take place to return their balance sheets to health, and future earnings capabilities remain unclear.

While banks suffered, commodities had a fantastic run, to the extent that valuations look stretched in some areas, despite the recent fall. There is still a long-term case for commodities, however, based on the structural supply-and-demand dynamics that will underpin the price of many commodities.

The possibility of a global growth slowdown leading to a significant short-term weakness in commodity prices must not be ignored. Investors can look to the periphery of industry, where there are still plenty of opportunities in a range of companies serving the resources sector. Weir, an engineering company for example, operates in several sectors including the mining industry, benefiting from sales of its mineral extraction machinery as well as strong after-sales service revenue.

Likewise, Wood Group, an oil services company, has the potential for further sustainable earnings growth over time through its range of products and services for the oil and gas and power generation indusShows the percentage year-on-year change in the Organisation for Economic Cooperation and Development leading economic indicators for various countries, from January 15, 2000, to July 15, 2008. Source: Datastreamtries. These companies provide a way to gain exposure to resources, while remaining relatively cushioned against volatile commodities prices as their earnings profile is more visible.

The effect of the global economic slowdown on commodity prices is just one manifestation of the sea change occurring in the investment landscape today. A year-and-a-half ago the benign environment of steady growth and low inflation, which was supportive of global equity markets for more than four years, was only just beginning to fade. Back then a mood of uncertainty prevailed, but today the belief that the environment for companies is unfavourable and unlikely to improve any time soon is undisputed. For example, globalisation works both ways, and it is likely that emerging Asia, particularly China, will not go unscathed as the extended deleveraging in Western economies continues.

The global economic slowdown is already leading to a reduction in demand, pulling down the prices of commodities, including oil, and easing inflationary pressure. However, this may give inflation-wary central banks more room to cut interest rates to stave off a recession, thereby leading to a reflationary environment that would benefit some of the areas that have suffered so much this year. This is one reason to be cautious about the extended bull run in mining stocks.

Overall, the outlook remains cautious, and there are benefits in maintaining a sensible degree of diversification through investment in quality companies with strong balance sheets. As we enter a period of continued uncertainty over the macro outlook, investors will pay a premium for companies with the potential for sustainable earnings growth.