How to find companies that deliver the best investment returns

With the current period of economic transition underway, Patrick Noble offers tips on qualities to look for in companies that will deliver the best investment returns.

2010 continues to be a grind for global share markets. Sovereign debt, austerity announcements, deleveraging, deflation, and fears of a hard landing in China have reinforced the wall of worry.

Even Australia has undergone a period of political uncertainty but the newly elected Labor Government will inevitably have an impact on some key sectors such as mining and telecommunications.

Each has been chipping away at market confidence and the bears have come out of hibernation.

Volatility too has been on the rise, but the price we paid to resuscitate the financial system remains a better alternative to economic oblivion.

The prospect of a V-shaped recovery has buoyed markets but weak economic conditions have overshadowed some strong earnings reports in global markets while excessive levels of debt continue to burden many parts of the world.

Maybe the worst is behind us but this does not make the path ahead any simpler and it is likely that deleveraging will play a prominent role in a global economy undergoing a prolonged period of transition.

No doubt investing will be a challenge, but to suggest there are no opportunities in equity markets is wide of the mark.

Rather, investors need to heed some fundamental lessons learned from the global financial crisis, such as differentiating between the qualities of companies they buy shares in.

Clearly this is a commonsense approach, yet a high proportion of companies with what could be considered poor quality balance sheets have enjoyed some of the best returns over the past 12 months.

Many of these companies were the ones, which flirted with bankruptcy during the financial crisis and may yet again find themselves starved of valuable capital in a more discerning market.

As such investors should remain wary of businesses that lack operational flexibility, have low margins or still possess a high degree of leverage on their balance sheets.

Conversely, companies with strong balance sheets and dominant market positions have lagged the share market rally over the same time frame.

These companies typically have a globally recognised franchise and generate large amounts of cash from their operations.

Sound management is also a key element for these businesses and how they choose to deploy this cash is a critical factor for investors to consider.

Strategic choices are either to invest in growth and migrate capital, or cut costs and/ or prices, or buyback shares/ pay dividends.

Companies that elect to engage in areas of fierce competition and price wars should be avoided, though those companies that have real investment opportunities (other than the promise of universal growth in areas such as emerging markets) are scarce and therefore valuable.

If improved efficiencies or expansion however, are not available, then the discipline to return capital is an acceptable, though still infrequent, choice for sound management.

Prevailing economic conditions and financial market volatility will ultimately separate the winners from the losers.

Investors need to avoid the temptation of blue-sky returns in junk rallies and focus on companies capable of navigating a difficult period of economic transition.

Investing in quality global franchises with good management teams at the helm will give investors exposure to attractive dividends paid from reliable streams of cash generation or companies with attractive reinvestment opportunities capable of growing their earnings into the future.

Patrick Noble is senior investment specialist at Zurich.