David Dierking, The Motley Fool
3 min read
When stocks begin selling off, problems tend to get exposed. Companies with struggling balance sheets, weak fundamentals, or a poor outlook are often hit the hardest. These factors can be overlooked when a bull market seems like a rising tide that lifts all boats. But the tailwind usually fades eventually.
The stock market isn’t selling off yet, but it’s certainly changing. The tech sector is still one of the best performers year-to-date, but the Magnificent Seven stocks as a whole are lagging, and the broader growth theme is struggling. Small-cap, value, and dividend stocks are now leading the S&P 500 as investors give more importance to valuations and financial health.
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When that happens, it’s a good time to revisit your portfolio to make sure you’re not overexposed to downside risks.
Verifying portfolio quality is the most important move you can make
The first step in any portfolio recheck should be to ensure that your current portfolio asset allocation and composition align with your goals and objectives.
If you’ve been buying and selling throughout the year or went heavy into tech and semiconductor stocks, your portfolio may have drifted from its target allocation. Consider rebalancing back toward it if you feel it’s drifted a little too far.
After that, ensuring your portfolio is filled with high-quality stocks can be the next step. Here are a few metrics to consider:
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Earnings growth: This is the bottom-line metric that suggests how well a company is performing. Earnings growth rates should be in a steady uptrend and not overly vulnerable to economic downturns.
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Free cash flow: This is the amount of money left over after a company pays its bills and reinvests in itself. Strong free cash flow provides the flexibility to fund growth initiatives, take advantage of investment opportunities, or even raise the dividend.
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Return on equity (ROE): This measures how efficiently a company uses shareholder capital to generate profits. Companies with consistently high ROE are usually demonstrating an ability to turn cash into earnings.
If you own a stock or ETF that hits on all three of these metrics, it probably qualifies as high quality. These are the companies that tend to withstand different economic environments and hold up better during market downturns.
