Five stocks to ride out the storm

The US economy is tipping into a new recession. "And there's nothing that policymakers can do about it," said Laksman Achuthan, co-founder of the Economic Cycle Research Institute (ECRI), last week.

Recession warnings are ten a penny scarcely a day goes by without another guru' pitching in their own contribution to the debate but this one is hard to shrug off. The ECRI's weekly index of leading economic indicators has a very good track record (predicting six of the last seven recessions) and the group takes pains to avoid false alarms.

A US recession is a particularly scary prospect. Yes, the crisis in Europe is hogging the headlines, but ultimately, as an engine of growth, America matters more than anywhere else. Between a fifth and a quarter of the planet's wealth (depending on the exact measure you use) is generated there. With China showing signs of slowing too, it's small wonder that stockmarkets have taken a pounding in recent weeks.

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Of course, many US citizens would argue that they never left the 2009 recession behind. The recent US recovery' has been scarcely worthy of the name unemployment remains historically high and more than 40 million people are on food stamps. But perhaps the most worrying thing about ECRI's warning is that this might be the shape of things to come. We are now headed into "an era of more frequent recessions" with shorter recovery periods in the middle. In short, "if you think this is a bad economy, you haven't seen anything yet. And that has profound implications for both Main Street and Wall Street."

What does that mean for your investments? The obvious conclusion is that, if the economy is weaker, we can expect more market turbulence, and for firms generally to face a greater risk of bankruptcy. So how can you protect yourself and grow your wealth? Sitting on cash is an option, and you should certainly hold more cash than usual, so as to be ready to pounce on opportunities as they arise. But with inflation eating away at your money, being 100% in cash is not a long-term solution.

When it comes to stocks, the answer is to seek out decent income-payers and ensure that they have what Tony Jackson in the Financial Times calls "the capacity to resist shocks which we cannot yet specify".

Why dividends matter

When share prices are rising, it's all too easy to view dividends as a bonus the real action is in capital gains. But thinking like this is a big mistake. Since 1925, for example, nearly half the return generated by the S&P 500 has come from dividends (on the assumption that they are reinvested, not spent immediately). That's thanks to the power of compounding. A £100 dividend may not seem like much at the time, but invest it over ten years at 5% a year, and it compounds up to a pot of £163, thanks to the ability to earn interest on interest. Wait another five years and you've more than doubled it.

See also

• A beginner's guide to dividends
• Video: What is a balance sheet?

But there's a catch. It's no use identifying a stock paying a nice dividend if it then lets you down when things turn nasty. A firm in trouble can cut or even suspend its dividend, meaning you can kiss that neat little compounding equation goodbye. So how do you check whether a stock is capable of weathering a full-blown recession? Or even several in a row? The answer is to look hard at a firm's balance sheet. As Jackson says, "while balance-sheet analysis may seem backward-looking, it has real predictive power in times like these".

The power behind a balance sheet

Balance sheets are made to look complicated by accountants, but they are actually simple. They sum up what a business owns (assets'), what it owes third parties (liabilities') and summarise how the net position (net assets') has been funded (shareholders' funds'). As the name suggests, it must balance (net assets must equal shareholders' funds) assets cannot be conjured out of thin air.

So if a firm has assets worth £200m and owes suppliers, banks and other creditors £50m, its net assets are £150m (in the same way that if your house is worth £200k and you have a mortgage of £50k, your net worth in property terms is £150k). That means shareholders must be funding the business to the tune of £150m either via shares previously purchased or their willingness to let the firm keep its past (retained) profits.

But why in the current climate is a balance sheet superior to a profit and loss (P&L) account? The answer is that it is cumulative, not a one-off. That makes it harder to fudge. P&Ls (and even cash-flow statements) only give you the good, or bad, news for a 12-month period. That makes them dangerously short term; a profit one year can turn to a calamitous loss the next; a firm that generates cash now could be eating it up next year. Balance sheets, on the other hand, represent the cumulative resources of a firm built up to date (or at least the last date the statement was prepared). They are in effect a snapshot of a firm's value not just its recent performance.

So a firm with a sturdy balance sheet can potentially withstand several years of being battered by P&L losses and even negative cash flows, whereas the same isn't true the other way around. Companies with weak balance sheets go to the wall fast when trading conditions deteriorate.

Of course, even balance sheets aren't foolproof as shown below. However, analysed correctly they can tell you lots about how storm-proof a firm might be. The good news is, thanks to a couple of finance professors Altman and Piotroski you don't need to be an accounting expert to do so.

The Altman Z score

Devised back in the 1960s by then professor of finance at New York University, Edward Altman, a Z score warns investors that a firm is at risk of going bust. Altman's model analyses the financial strength of a company using five ratios built on key numbers mainly taken from a firm's balance sheet, along with a few from the P&L. Each ratio is then weighted to reflect its relative importance before the five are added together to generate a Z score (usually a single-digit figure). The five components are as follows.

EBIT to total assets: This is the most heavily weighted in other words, most important component of the Z score. EBIT is earnings before interest and tax, or operating profit. This ratio shows how productive a company is in earnings terms, relative to its size. More efficient companies tend to be better placed to thrive during hard times.

Retained earnings to total assets: This indicates the cumulative profitability of the firm, again compared to its overall size. Shrinking profitability is a warning sign. This measure can also show how highly geared (indebted) a company is, since high retained profits suggest it may have financed assets through profits rather than debt.

Working capital to total assets: This compares liquid assets, called working capital' or net current assets', to the total long (fixed') and short-term (current') assets on the balance sheet. A troubled firm will usually suffer shrinking liquidity as sales fall or costs rise, the amount of easily available cash will fall.

Sales to total assets: This measures how effectively the firm uses its assets to generate sales. A firm in trouble will turn its assets over slowly.

Market capitalisation to total liabilities: This tests how far a company's assets can decline before the firm becomes technically insolvent because liabilities exceed assets.

You could calculate these ratios then weight them by hand. But it's faster to feed the relevant numbers into an online Z score calculator: try Creditguru.com/CalcAltZ.shtml. So what does it all mean? The weaker the Altman score, the greater the chance of a firm suffering financial distress within the next two years. A score of around or below about 1.6 is a warning sign. And those with a score of below one tend to underperform the market, notes Morgan Stanley's Graham Secker, "particularly in recessionary periods". Taking the period from 1990 to 2007, the average compound annual growth rate (CAGR) for these stocks was 3.3% against a median average of 4.1%.

The Piotroski score

Designed by Joseph Piotroski, at the time professor of accounting at University of Chicago, the Piotroski F-score uses nine recent criteria to test for balance-sheet strength. A firm scores a point for each test it passes and zero for a fail, based on the most recent set of annual accounts. I won't run through them all here, but Piotroski is basically trying to see if a firm's financial outlook is improving or deteriorating. So it looks at whether or not a firm is profitable, and if it is generating cash, and whether its ability to do so is improving or not. It also considers whether debt is falling or rising, and if the company's ability to repay debt is improving or deteriorating.

The higher the score the better, with nine being the top score. So does it work? Graham Secker is convinced it does. "We have simulated the returns to a strategy that goes long a basket of (non-financial) stocks with a Piotroski score of 7-9 and short a basket of stocks with a Piotroski score of 0-2. Such a strategy would have generated compound outperformance of 6.6% a year between 1990 and 2011." Better yet, this strategy is "particularly successful in years of economic recession and/or equity bear markets".

No magic number

Sadly, successful dividend investing isn't reducable to a single number. As Tim Price of PFP Group puts it, "we would never use Altman in isolation". There are several reasons for this. Even balance sheets don't always reveal the full picture (see below). While the Altman Z score has a decent success rate (70%-80%), nothing's foolproof. Like Piotroski, it's hopeless for banks. But combined with other measures of dividend safety, both can give you a great platform for hunting down robust income stocks. So what do they flag up as good buys now?

What our screen is telling you to buy now

The aim is to identify stocks with a reasonable, sustainable dividend yield. That means the dividend should be well covered, and backed by balance-sheet strength. The bedrock for the selection is a screen devised by Tim Price at PFP Group. He uses the Altman Z score combined with four other measures:

1. The forward dividend yield: the expected annual dividend as a percentage of the share price the higher the better.

2. Dividend cover: this is how you make sure that a firm can keep paying out. This checks how many times one year's profit before dividends covers the annual dividend twice or higher is ideal.

3. The forward price earnings (p/e) ratio: this is a measure of how cheap a share is the lower the better from a value investing perspective.

4. Total debt to assets: a measure of a firm's financial risk, or gearing' again, the lower the better, with zero debt being best.

To this we have added the Piotroski score favoured by the likes of Morgan Stanley's Graham Secker as a core part of his value stock screen. Finally, we have been sector-sensitive. Most financial stocks are not on the menu at the moment as asset prices continue to plunge in most markets and the scale of liabilities particularly within Europe remains unclear. And whatever you buy, with so much uncertainty about, you want to hold stocks across a range of sectors to reduce the risk of your entire portfolio failing should the environment turn really brutal.

The tablebelow shows five FTSE 350 companies that score well on these measures. These are high-street baker Greggs; polymer producer Victrex; precision engineering firm Renishaw; household products giant Unilever, and energy consultancy and project manager Amec.

The hidden nasties

Financial journalists are often taught to read a set of accounts backwards. If there are any juicy stories to be had, that's where they'll be. You can learn from that: useful though they are, balance sheets won't always give you the full picture in terms of what could go wrong for a firm. Always read the notes at the back of the accounts too. Here are three worth hunting down.

Operating lease commitments

When firms sign deals to lease assets, they take on big future commitments to pay rent. Failure to do so can result in penalties and court cases. But a balance sheet will tell you little about the size of these off balance sheet' liabilities. At failed care-home operator Southern Cross, for example, these had reached £6bn by 2008.

Related party transactions

This reveals details of deals between a firm and its directors, or people close to the directors. If the note has anything in it at all, you need to know why, especially if there are signs of transactions involving directors being done on non-commercial terms. Robert Maxwell used to boost sales booked and the closing stock valuation of his then public company (Mirror Group Newspapers) via sales between MGN and one of his private firms.

Contingent liabilities

If a firm has an obligation to pay, say, a supplier, it books the full amount owed in the balance sheet. But if it faces, say, a huge unsettled court case, it may post nothing there at all. To find out more read this note it's where tobacco firms tend to deal with ongoing group actions, for example.