This will probably be stockpickers’ year. Investors have taken the early gains on risky stocks and will now be focusing on quality companies — rewarding those that grow their earnings and punishing those that don’t meet expectations.

Today’s more discriminating investors are on the hunt for stocks with good earnings growth potential and not too much risk, says Norman Raschkowan, chief investment officer at Mackenzie Financial Corp. in Toronto. He says this shift to quality favours large-cap companies, particularly those with good management, healthy balance sheets, sound business-growth models and the potential to take market share from weaker rivals.

“For example, we’ve started to see a difference,” notes Raschkowan, “between Goldman Sachs Group Inc. and JPMorgan Chase & Co., which are strongly financed and in a position to grow market share, and Citigroup Inc., which still has to shrink and downsize.”

Citigroup’s stock closed at US$3.52 a share on Jan. 12, up from its low of US97¢ in March 2009 but down from US$5.43 this past August and miles below its US$57 high in December 2006.

In contrast, JPMorgan’s stock has consistently moved up from its March 2009 low of US$14.96 a share to close at US$43.49 on Jan. 12, which is within shooting distance of its May 2007 high of US$53.25.

Goldman Sachs is a similar story, closing at US$167.82 a share on Jan. 12 vs a low of US$47.41 in November 2008. Its high was US$250.70, reached in October 2007.

Investors know strong balance sheets mean companies won’t be paying high interest charges as they roll over debt. Investors also know the firms’ ability to generate cash flow will create the funds to grow, both organically and through acquisitions, says Raschkowan. He expects merger-and-acquisition activity to remain “very elevated” this year.

Quality companies also tend to have pricing power, either because of their service level or their dominant position in their markets. Raschkowan points to Montreal-based Astral Media Inc. and Corus Entertainment Inc. of Toronto, which offer specialty TV channels: “Demand is strong, growing and taking share from traditional media.”

Although most global money managers agree that the emphasis needs to be on quality, their definitions of “quality” vary somewhat.

This depends partly on their outlook for global growth. Those who are pessimistic about the U.S. economy put particular emphasis on balance sheets and a very undervalued stock price.

Ross Healy, president of Strategic Analysis Corp., in Toronto, who expects the U.S. economy to stagnate for a long time, looks for companies that have bulletproof balance sheets without a lot of goodwill.

Healy strongly recommends removing goodwill and intangible assets when analyzing balance sheets, noting that this can make quite a difference to the picture that emerges. He notes that if investors had removed goodwill and intangible assets from the books of Nortel Networks Corp. when its stock was riding high, they would have seen the warning signals of the plunge in the stock price before it occurred.

Nandu Narayanan, chief investment officer at Trident Investment Management LLC in New York and manager of several mutual funds for CI Financial Corp. of Toronto, adds that investors should make sure there isn’t a lot of leverage on a balance sheet. He foresees little growth in U.S. consumer spending, which will cause that country’s economy to double-dip back into recession, an environment in which it will be difficult to generate earnings growth. If there is leverage, he says, a company’s core business needs to be “really good —– high quality and, if [it’s] a consumer company, it shouldn’t be selling a lot to the U.S.”

Narayanan is finding some of these types of companies among U.S. multinationals, such as Procter & Gamble Co., Johnson & Johnson and Pepsico Inc. “They have very good brands,” he says, “and sell around the world.”

He adds that companies that can do well in an inflationary world can be good bets. He expects debt-laden governments, such as the U.S., to encourage inflation because that would make debt repayment easier. Procter & Gamble and Johnson & Johnson, for example, would be able to raise prices should inflation take off. Their products are everyday items that people have to keep buying, regardless of economic conditions. Also, these firms’ strong brands ensure that consumers are likely to stick with them rather than switch to lower-priced alternatives.

@page_break@Those analysts more optimistic about U.S. — and, thus, global growth — put more emphasis on being in the right markets. It’s important to “focus on companies, sectors and countries that have the wherewithal to grow beyond the initial bounce,” says Fred Sturm, executive vice president and chief investment strategist at Mackenzie.

Charles Burbeck, an independent global money manager in London, England, agrees: “You want to be geared to growth.” He suggests looking for “companies in cyclical industries that are exposed directly or indirectly to emerging markets.” This can include resources companies or industrials, which benefit from the strong growth in emerging markets, and firms involved in servicing those markets, such as shippers and industrials geared to infrastructure.

Burbeck adds that industries with barriers to entry are particularly desirable, as long as they also have good growth prospects.

The “right” sectors can vary according to where companies are located. In Europe, for example, exporting globally is a major theme. (See story on page B16.) Even though the high value of the euro makes it difficult for European companies to be competitive in foreign markets, domestic demand is expected to be just as sluggish in Europe as it is in the U.S. So, investors should look for quality companies that have real growth prospects, such as those selling to fast-growing areas such as China and other emerging Asian and Latin American economies. In these areas, consumer spending is rising quickly as more and more of the population becomes “middle class.”

In contrast, managers of Asian and other emerging-markets funds are focused less on the stocks of exporting companies — at least, those whose main market is the industrialized world. The emphasis is more on companies benefiting from growth of consumer spending in emerging markets or involved in resources for which demand is strong because of those markets’ infrastructure spending. (See stories on pages B6 and B14.)

Quality companies have a number of other desirable characteristics. “You want companies with industry leadership that pay dividends and have a track record of increasing those dividends,” says Andy MacLean, director of private-client strategy with Richardson GMP Ltd. in Toronto.

However attractive a company may be, investors also don’t want to pay too high a price. That price depends, of course, on the investor’s assumption about growth. For Healy, given his belief in a long period of U.S. stagnation: “The ideal buys are stocks of companies whose price is below their break-up value.”

But even if the U.S. economy recovers, investors still don’t want to pay too much. “We won’t overpay for growth and avoid really stretched valuations for countries and companies,” says Bill Sterling, CIO with Trilogy Advisors LLC in New York. “We’re accumulating shares of really good companies.”

In the same vein, Peter O’Reilly, global money manager with I.G. Investment Management Ltd. in Dublin, doesn’t hold Apple Inc., even though it’s one of the best companies in the world, because he doesn’t see a lot of upside, given its current valuation.

And a word of warning from John Arnold, portfolio manager at AGF International Advisor Co. Ltd. in Dublin. He notes that investor expectations about future earnings, even of quality companies, are often exaggerated — particularly in recovery periods.

Arnold prefers to buy companies that have been hit by tough but solvable problems. Most investors don’t usually anticipate that management can fix the problem, so the earnings growth can surprise — allowing him to purchase stocks before they go higher and their multiples expanded.

Arnold’s rule for investing is to consider only those stocks that have a price/earnings ratio of at least 30% below the market average, a dividend yield that’s 30% above average and a share price that is 30% below its 18-month peak. IE