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How to find quality companies – 3 share ideas

With so much economic and stock market uncertainty, it’s becoming more difficult to find quality companies. Here’s one way to find them and three companies that could thrive.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

With economic uncertainty and the prospect of more interest rate hikes all weighing on the market, it’s becoming more difficult to find quality companies with the potential to thrive.

As the economic cycle spins on, the lows we’re set to experience allow the cream to rise to the top. It’s in these times that companies with viable businesses and strong cash generation are able to knock out competitors, acquire struggling peers, and march to the top of their industry.

One way to search for this type of company is to look for cash on the balance sheet. While this shouldn’t be your only criteria, it’s a good way to get a quick snapshot of financial health.

Net debt will tell you how much of a company’s profits are left once its obligations have been deducted. It’s a good thing to have when times are lean. That’s because it gives management the freedom to think strategically about the bigger picture, rather than operating in survival mode.

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With that in mind, here’s a look at three companies sitting atop sizable cash piles.

This article isn’t personal advice. If you’re not sure if an investment’s right for you, seek advice. All investments and any income they produce can rise and fall in value, so you could get back less than you invest.

Investing in individual companies isn’t right for everyone – it’s higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

Balfour Beatty

Balfour Beatty is an infrastructure company that manages construction projects from financing to building and maintenance. Being in the business of building new things can be tough when the economy slows down, which is why a strong balance sheet is paramount.

Balfour’s sitting on over £400m in net cash, expected to grow by 50% over the next year. That puts the group in a strong position to thrive while competitors are treading water.

Balfour had to swallow the cost of projects that went wrong due to the pandemic. But it’s pushed the group to become choosier about the quality of the projects it takes on. This should put Balfour in a strong position to weather a period of economic uncertainty, but it means the order book isn’t quite so robust.

The public sector accounts for a large chunk of orders, 90% in the UK. That puts the group in a good spot, as long as governments remain committed to spending on infrastructure. Given the momentum around the shift to net zero, it’s unlikely that spend on things like carbon capture, nuclear infrastructure and improving the electric grid will be rubbed off budgets anytime soon.

Getting that incoming cash through to the bottom line is something of a struggle for construction companies like Balfour. Profit margins for the sector have tended to be in the low single digits, and Balfour’s expected to deliver 2.4% this year. Improvements on this will be minor though, which is the nature of working in construction.

Inflation looms as a risk to these already thin margins, but the group’s doing what it can to manage these. As a big fish, Balfour has more bargaining power when it comes to negotiating contract terms with its suppliers. Plus, many of the group’s projects have some inflation protection built in to the agreement.

Balfour Beatty margins

Source: Refinitiv, 04/07/22. *expected figures

That brings us to the group’s 3.8% prospective dividend yield. After slashing pay-outs to cope with the pandemic, Balfour’s restored its dividend. Keeping up with a progressive dividend growth policy is Balfour’s intention. But that’s dependent on profit growth, so there are no guarantees. Remember, yields are also variable.

We can’t gloss over the fact Balfour’s business is somewhat at the mercy of the wider environment. That’s a risk reflected in a price to earnings ratio which is well below the long-term average. But, a strong position in the public sector, together with strong finances could make the group worth considering for the long-term. Some ups and downs in the near term are likely to be expected.

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Big tech companies in the US sit atop some of the heftiest cash piles in the world. That means they have the firepower to gobble up competitors and invest in growth.

But the tech sector is facing somewhat of a reckoning right now. Uncertainty among some of the top players means some could see their cash start to dwindle as they pedal harder to keep up. It’s made it more difficult to suss out which of these enviable cash piles can be used to drive shareholder returns forward.

Amazon, with just shy of $19bn in net cash on the balance sheet in the first quarter, is worth talking about.

The group’s ecommerce business has been under the pump lately as a push to build out fulfilment capability was met with gusting inflationary headwinds. The result was an operating loss from this part of the business in the first quarter. Amazon’s planning to turn things around with improved efficiency throughout the network, but only time will tell whether the group can bring costs down fast enough.

Luckily Amazon’s cloud arm, AWS, is profitable enough for both of them. Investment in this part of the business is paying off and the growth runway in cloud computing continues to stretch out well into the future.

Amazon 2021 revenue breakdown

Source: Refinitiv, 04/07/22. Figures won't add up to 100% due to rounding.

Services are becoming a much larger slice of Amazon’s strategy, and we applaud this move. These tend to be higher-margin offerings and could help offset the capital-intensive nature of the e-commerce business. Advertising is one such new initiative that has promise. This is especially true as we march into a period of economic hardship.

As companies’ budgets shrink, they’ll be more careful about where they focus their marketing efforts. This is a trend we’ve seen start to play out among some of the biggest advertisers, sending their shares in a tailspin.

Amazon’s advertising arm comes packed with invaluable customer data, and that’s something that will likely draw in potential clients that want to make the most of their ad spend. Plus, there’s much less friction to buy something when they’re already on an e-commerce site, versus seeing an ad while scrolling social media.

While its diversified business offers some cushion, Amazon isn’t immune to the impact of inflation and a wider economic slowdown. The group’s valuation has come down significantly below the long-term average. But at 64 times forecast profits, expectations are still very lofty and that opens the door for near-term volatility.

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Housebuilders find themselves high up on the list of cash-rich FTSE constituents. That’s in part because they’re operating in a relatively buoyant environment. They also carry a lot of their debt in what’s called land creditors. These are agreed purchases for land that have yet to be paid, and are essentially a form of debt.

Persimmon was sporting a net cash position of £446m at last check, and with land creditors of £160m, the group’s balance sheet is still on firm ground.

That’s a strong position to be in as economic concerns rattle the market. A big part of the investment case for Persimmon is the group’s 12.8% prospective dividend yield. Part of the reason that’s climbed so high is that the share price has fallen given the challenges ahead. But it’s also a product of Persimmon’s aim to return a portion of its excess cash to shareholders. Remember though, yields are variable and no dividend is guaranteed.

Lately, there’s been quite a lot of excess cash floating around – at the full year, the group’s free cash flow was well over £750m. That’s thanks to industry-leading operating margins of over 26%.

Housebuilder operating margins

Source: Refinitiv, 04/07/22.

Persimmon’s somewhat of an expert in flipping unusable land to create housing developments. The group buys land without planning permission which it later develops. This is far cheaper than buying land ready for building, which pads profits when the houses are ultimately sold. Together with the group’s in-house materials business, this is helping to keep stubborn inflationary headwinds from eating into profitability.

There’s been a rising tide of concern about the housing market, which has seen unprecedented demand in the wake of the pandemic. But we think Persimmon is well-placed, even if the market starts to cool.

The group’s private average selling price of £259,231 is firmly below the national average. That means the group’s catering primarily to first-time buyers, who have heaps of government support to get on the ladder. While the support has thinned somewhat in recent years, it’s unlikely to evaporate anytime soon.

The ongoing housing shortage is likely to continue motivating lawmakers for the foreseeable future. With rental costs growing and 95% mortgages now available, there’s a good deal of incentive to get on the ladder.

There are chinks in Persimmon’s armour though. Its buyers are those who would be hardest hit by a recession. With a price to book ratio below the long-term average, some of these risks have already been priced in. But given the current uncertainty, we’d expect some ups and downs to come.

View the latest Persimmon share price and how to deal

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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