Cultivate a keen eye for the bottom line

This is it. The annual profit-reporting season has kicked off and with it comes a chance for investors to peek under the bonnet and kick the tyres of stocks they own or would like to own.

Lincoln Indicators chief executive Elio D'Amato says the market is focused on potential risks. There are question marks over the growth prospects of non-mining sectors of the economy. There is also a federal election coming up, with politicians making policy at 30 paces.

"In an environment like this, you need to make sure that companies are financially healthy so they can absorb any shock to their business," D'Amato says.

But with more than 2000 companies listed on the ASX, deciding which ones to buy and hold, and which to consign to the scrap heap, is a daunting task. Montgomery Investment Management chief executive David Buckland begins by whittling the choice down to 600 companies that make money. Of those, about 150 have announced earnings downgrades in recent months.

"Try to avoid companies with earnings downgrades and where the reported outlook for 2014 is worse than previously anticipated," Buckland says. "It's difficult for a company's shares to perform if they are downgraded."

Watch the miners

One theme this year is the state of the resources sector and the service companies that depend on it. It has been widely reported that mining companies have cut back capital expenditure and exploration on the back of falling commodity prices, and this has had flow-on effects for companies that service the mining industry. "Logic says that earnings for mining-services companies are likely to be lower next year and therefore it is harder for their shares to perform," Buckland says. However, D'Amato thinks resources stocks may have been oversold.

"We are quite confident that the mining sector isn't dead," he says.

"If BHP, Rio and the other big miners come out with good results - and we expect them to, based on the latest June quarter production reports - there may be opportunities to buy a long-term holding."

Dividends

Buying shares for their dividend income has been a popular strategy for the past 18 months and this is likely to continue while interest rates are low. D'Amato expects there will be strong market support for companies that continue to increase dividends.

But dividend growth is only sustainable if the underlying business is sound. You can tell a lot about a company's prospects from directors' statements but you also need to check the figures. The first thing to look for is a history of profits and the ability to keep growing them. Retained profits are the cheapest form of finance if a company is to continue paying dividends and meeting its business expenses.

While growth in earnings per share is a good indicator of profitability, Buckland says it is important that return on equity (after-tax profits divided by shareholders' funds) is keeping pace. If this is falling, it is a signal that the company may need an injection of funds to sustain growth.

"You need to be wary if there is ongoing decline in return on equity," Buckland says.

High debt and cash-flow problems are also signs that a company's position is deteriorating. During the financial crisis, investors learnt the hard way that high debt can kill a company if the market turns against it. Look for a debt-to-equity level of well below 100 per cent and note how much company debt is short-term versus long-term debt that can be delayed if necessary.

And if a company doesn't have positive net cash flow it won't be able to meet its ongoing expenses. If it gets these things right, D'Amato says, investors can be confident it is strong enough to absorb any short-term shocks and ride out the cycle.

The falling dollar

Financially healthy companies are also best placed to take advantage of emerging opportunities, such as the fall in the dollar against the greenback from $1.05 to below 90¢.

This means a 10 per cent to 12 per cent revenue boost for companies with offshore earnings. "Companies with a large proportion of their revenue in US dollars will get a shot in the arm," Buckland says, citing medical companies such as CSL, ResMed, Cochlear and Sirtex Medical. Conversely, importers such as specialty retailers of overseas manufactured goods face a 10 per cent increase in costs. "[The falling dollar] won't affect 2013 earnings but it will affect 2014."

Attractive price

Identifying good companies is one thing, but you will only make money if you buy and sell at the right price.

Stocks in the telecommunications, healthcare and financial sector have experienced strong growth in the past year, pushing their share prices above intrinsic value. Even though many of these are great businesses, the market could react negatively if their results fail to meet expectations.

"This may be a good time to take some profits off the table and use the cash to take advantage of opportunities the reporting season will throw up," D'Amato says. He says the consumer-discretionary sector is one to watch, singling out Corporate Travel Management, Flight Centre, Carsales.com.au, REA Group and a small retail-investment company, RCG Corp.