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Keep the Focus on Balance Sheets

Chief Investment Officer—US Large Cap Value Equities and North American Value Equities; Global Head—Diversified Value Services
August 29, 2011

Nobody likes uncertainty, least of all equity investors. These days, there’s plenty to be concerned about, and with memories of the 2008 market crash still fresh, many people are selling first and asking questions later.

By my reading, what all this uncertainty boils down to is a deep apprehension about the future of both global economic growth and corporate profits. It’s difficult to forecast the near-term macroeconomic outlook with any reliability, particularly when politics are influencing so much of the outcome.

In such an uncertain environment, what’s the best course of action? Well, I think it’s to try to focus on what we can observe rather than on what we can only speculate about. That means investing in companies with good shock absorbers—namely, strong current profitability and healthy balance sheets.

These two characteristics provide tangible evidence that the value I see in a company is really there. If the company is already profitable under current conditions and if the elements driving that success look sustainable, I can have more conviction about the company’s ability to meet my long-term earnings expectations and its investment potential. If the company also has a strong balance sheet, I can have more confidence that it can weather near-term storms, take advantage of the weaknesses of other companies and flourish once good times return. In short, investing in companies with these characteristics lets me sleep better at night.

Quality isn’t hard to find right now. Forecast return on equity (ROE) for companies in the S&P 500 Index was 18% at the end of July 2011, up from 14% at the end of February 2009. After several years of robust profit growth and the husbanding of capital, the free-cash-flow margin for the S&P 500 is 7.5%—well over its 5.3% average since 1994. And its net debt to equity is at its lowest levels in decades.

What’s truly remarkable is that today we are able to invest in companies with an ROE similar to or higher than the market’s, higher free cash flows, and balance sheets as good or better than the market’s—at substantial discounts to the market based on forward earnings and book value. And these discounts are roughly comparable to those at the peak of investor anxiety in early 2009.

It may seem unusual for a value manager to be seeking quality. It’s more common for us to buy the stocks of troubled companies that we think have been unduly punished by the market. But being able to invest in quality at a discount is a rare opportunity. I’m moving on it.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio management teams.

This article first appeared on Institutional Investor.com as part of its Global Market Thought Leaders section.

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