Sector Screener: financially sound stocks with growth potential

Focusing on the long run, rather than the short term, is one of the greatest challenges of stock market investing. Indeed, too many investors allow their viewpoints and opinions on sectors and individual companies to be heavily influenced by near-term prospects, rather than long-term potential.

• Invest with ii: Top UK Shares | Free Regular Investing | Open an investment Account

Given that the world economy’s performance, as well as that of most sectors and firms, ebbs and flows as part of a long-term cycle, investors who fail to avoid short-termism often end up buying during the stock market’s peaks. They also typically sell, or at least fail to buy, during its troughs. This can lead to disappointing long-term returns as they miss out on the most attractive opportunities through which to generate capital growth.

Short-term challenges

At present, many investors are avoiding cyclical firms because they face an uncertain near-term future. Since their financial performance is relatively sensitive to the economy’s growth rate and prospects, such companies are being negatively affected by weak global GDP growth to a greater extent than other firms.

The US economy, for instance, expanded at an annualised rate of just 1.6% in the first quarter of the year. This is its slowest rate of growth since the second quarter of 2022. Meanwhile, the eurozone and the UK only recently exited recessions and are expected to post GDP growth of less than 1% apiece, according to the International Monetary Fund (IMF), in the current year. And with China’s economy continuing to be weighed down by property market weakness, the near-term outlook for the world economy is relatively uncertain.

• Sign up to our free newsletter for share, fund and trust ideas, and the latest news and analysis
• Inflation eases to 2.3%, but hopes of imminent rate cuts dashed

Given that inflation is proving to be somewhat stickier than many investors had anticipated, and the full impact of interest rate rises is yet to be fully felt due to the presence of time lags, the near-term prospects for cyclical firms remain highly challenging. This may continue to dissuade many investors from buying shares in such companies.

Source SharePad. Data as at 22 May 2024. Past performance is not a guide to future performance.

Source SharePad. Data as at 22 May 2024. Past performance is not a guide to future performance.

Long-term potential

However, investors who can look beyond short-term economic challenges that are highly likely to prove temporary, and instead take a long-term view, could generate significant investment returns. Although the rate of inflation is falling at a slower pace than previously expected, it is nevertheless widely forecast to meet central bank targets in the US and eurozone over the coming months. UK inflation has just fallen to 2.3%. This should create an opportunity for policymakers to adopt a more dovish stance regarding interest rates that, following the passing of time lags, acts as a positive catalyst on the world’s GDP growth rate.

Due to their dependence on the world economy’s prospects, cyclical firms are likely to be significant beneficiaries of its upbeat long-term outlook. Demand for their variety of products and services should increase, which is likely to translate into higher sales and profitability that ultimately catalyses their share price performance.

High-quality companies

Of course, firms that are highly dependent on the economy’s performance must first survive a tough operating environment before they can reap the benefits of improved GDP growth. Investors should therefore ensure that any company they buy has a solid financial position. This means it should have only modest levels of debt alongside operating profits that are sufficiently high to pay interest costs several times over.

• Stock markets at records and cash at 5%: what will happen next?
• Stockwatch: what now after ISA tip’s 70% profit in two months?

Investors should also seek to purchase companies that have a clear competitive advantage. This is, of course, subjective but an analysis of measures such as average return on equity over a period of three or five years, for instance, can provide a useful guide. Meanwhile, obtaining a margin of safety when purchasing a cyclical firm is likely to prove beneficial. It protects against paper losses in the near term, and provides greater scope for capital gains as the economy’s performance improves over the long run.

Buying opportunities

A challenging near-term economic outlook is reflected in the recent performance of the FTSE 350 Electronic & Electrical Equipment sector. It includes a variety of cyclical companies and has declined by 1.9% over the past year as investor sentiment has weakened. This compares with a 8% gain for the FTSE 350 index over the same period. However, the sector contains several high-quality companies that offer long-term capital growth potential.

Source SharePad. Data as at 22 May 2024. Past performance is not a guide to future performance.

For example, FTSE 100-listed engineering company IMI (LSE:IMI) offers a favourable risk/reward opportunity. The firm’s latest quarterly trading update highlighted its disappointing financial performance amid a tough period for the world economy. The designer and builder of products used in fluid and motion control applications, such as valves used to improve the efficiency of heating systems, generated organic revenue growth of just 4%. This compares with a growth rate of 8% in the same period of the prior year.

It also stated that it is on track to deliver growth in profits of only 5% in the current year. Although this forecast is in line with the firm’s previous guidance, it represents a significant downgrade on the 11% growth rate delivered last year and the 12% annualised growth rate produced since 2019.

• Share Sleuth: the new holding I’ve picked to reduce my cash pile
• Insider: boardroom buying at AIM company with royal approval

However, IMI is a high-quality business that has the financial strength to not only overcome a tough period for the world economy, but also invest for long-term growth. For example, its net gearing ratio stands at a relatively modest 62%, while its net interest cover last year was around 18. And with an average return on equity figure of 30% over the past five years, it has a clear competitive advantage that is likely to translate into improved financial performance as demand for its products increases amid an improving global economic outlook.

Trading on a price/earnings ratio of 16.2, the company’s shares are by no means cheap on both a standalone and relative basis. But with the firm implementing a restructuring programme that is set to result in a simpler and more efficient business, as well as having diverse geographic exposure that reduces overall risk, its investment appeal is relatively high on a long-term view.

Solid fundamentals

Similarly, FTSE 250-listed Renishaw (LSE:RSW) offers long-term investment potential despite its uncertain near-term outlook. The company, which specialises in precision measurement and process control products that are used across a variety of industries, recently released a mixed trading update that showed revenue in the first nine months of its current financial year was unchanged versus the prior year at constant currency.

The firm also maintained the lower bound of its profit expectations for the full year but reduced the upper bound of its guidance. Based on the mid-point of its upper and lower guidance, the company’s pre-tax profits are now set to decline by around 9% versus the prior year. While this would represent a disappointing outcome, the firm remains financially sound, as evidenced by a net cash position of roughly £164 million. It also has a solid competitive position, as demonstrated by an average return on equity figure of 16% over the past three years in spite of utilising very little debt.

• 10 mid-cap shares investors should own in 2024
• Stockwatch: a major turning point for UK economy and stock market?

Of course, uncertainty surrounding potential bids for the company and the question of succession planning regarding the firm’s longstanding management team could prompt elevated share price volatility in the short run. However, the company is fundamentally sound and is pursuing productivity gains that are set to boost its financial outlook amid an improving operating environment.

As with IMI, Renishaw’s PE ratio of 26 is relatively expensive. But as the company’s profitability rises in response to a more buoyant global economic outlook, its share price is likely to do likewise.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.