European market turbulence is sending investors scurrying in search of safe havens. Stocks with standout earnings quality seem to offer what they seek: a combination of upside potential and solid returns.

In the current market environment, there are few rewards for those brave enough to stick their necks out. In particular, given the ongoing turmoil in the eurozone (thoroughly chronicled in this recent e-book from Reuters Breakingviews), investors can’t be blamed for preferring to huddle in safe havens, rather than attempt to navigate markets roiled by the apparently endless and certainly very complex fiscal negotiations aimed at resolving Europe’s sovereign debt woes.

Released: August 8 2012
Length: 3 Minutes

The anxiety of investing in European stocks can be lessened by focusing on companies with higher StarMine earnings quality ranking, as can be seen in this 3 minute video.

One example of that market uncertainty is the difficulty in gauging whether a company’s recent earnings are sustainable in coming quarters. That’s a tricky question, especially in periods of volatility, but it’s one that can be measured using StarMine’s Earnings Quality (EQ) model.

That’s why we set out to scour stock markets across the developed economies of Europe in search of companies with very high EQ scores. We began by screening all stocks in across developed Europe and identifying those with scores that registered in the top 10% of all their peers in the region.

A high EQ score alone isn’t enough, however. StarMine research has shown that EQ scores are higher when they are supported by strong cash flows; meanwhile, operating efficiency also is a key contributor to earnings quality. Therefore we examined each of the companies identified by our first screen more closely, looking for cash flow and operating efficiency – that ranked in the top 20% among companies in the region. Since a stock that looks like it is good value can also be a value trap – i.e., a good value whose share price stubbornly refusing to climb for a prolonged period of time – we applied StarMine’s Value-Momentum model to the screening process, to further qualify the number of remaining candidates.

The result? Our final list of companies in Europe’s developed economies – from Greece to Norway — contains 25 businesses that offer investors earnings quality that appears to be well above average for the region. Some of these companies are those that you might expect to find on any list of this kind, such as the fortress-like businesses of pharmaceutical giants Novartis (NVS.N), Roche Holding AG (RHHBY.PK) and AstraZeneca PLC (AZN.N). But the screen also highlights less well-known names that one wouldn’t automatically assume to boast stellar earnings quality, including luxury goods manufacturer Salvatore Ferragamo (SFER.MI), gaming company William Hill (WMH.L), Irish-based energy company Dragon Oil (DGO.L) and, in the technology stock universe, United Internet (UTDI.DE).

These stocks have fared better than their peers when it comes to performance so far this year (as of August 1, 2012) as well as in earnings quality. The companies in the model portfolio gained 17% in price alone in the first seven months of the year, compared to an 8% gain for Europe’s Stoxx 600 Index.

 
Admittedly, building a portfolio containing high EQ companies from developed Europe may require investors to accept a tradeoff, swapping slightly lower growth rates for above-average earnings quality. Analysts are calling for the companies in this high-quality portfolio to generate five-year earnings growth of around 4.4%, below the 6% they expect the Stoxx 600 index companies to report.

Safer, if slightly smaller returns, versus higher rates of earnings growth from companies that can’t offer the same kind of earnings quality? The decision is up to investors, but many already seem to be allocating their capital to companies that appear to offer a degree of safety along with some upside potential, with their above-average earnings quality being reflected in above-average stock price gains. The odds may well continue to favor these companies during the final months of the year, given that they appear likely to continue to offer a scarce but highly valued commodity: solid earnings quality.

 
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