The last month may be only the beginning of the beginning of market turmoil, so we have taken extra steps to  scrutinize the safety and resiliency of Global Income Edge holdings. 

In our February issue  (Feb. 12) we’ll publish a company-by-company stress analysis to show why our conservative holdings (the portfolio currently yields 4.8%) are well-positioned to deliver income during these volatile times. 

But given that issue is a couple weeks away and investors are nervous now, we’ll share some of our initial results in this e-letter.   

Times are tough. So much so the International Monetary Fund and the World Bank’s economists have lowered global growth forecasts. And Wednesday the Federal Reserve said it was putting a hold on rate hikes given those global growth concerns.

The signs of strain are showing in a number of places beyond stock markets. For example, default rates for U.S. corporate bonds have overtaken default rates for emerging markets corporates, according to new data published by Bank of America Merrill Lynch.

Still, we are hopeful that gains in U.S. employment and low oil prices will boost consumer spending and offset global weakness.

The Banker’s Umbrella

If the global economy continues to worsen, the first thing that will quickly disappear is credit. As Mark Twain said, “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.”

If markets turn for the worst and credit tightens, only those firms with the strongest balance sheets, pricing power and economies of scale will weather the economic storm. Finding those firms is the central goal at Global Income Edge.  

Many investors often fail to take into account the disastrous impact of tightening credit conditions on businesses, when demand growth starts to stall. That’s why I constantly test our portfolio companies’ profitability, as well as their use of debt or leverage and how they might be affected by worsening conditions.

Here is a brief review of various analyses that I conduct on our portfolio holdings:

GIE Early Warning System This is a proprietary financial model I developed for income investments. It breaks a company’s return on equity (ROE) into its individual components, which makes analyzing what’s actually driving growth easier. In addition to identifying promising investments, this system alerts us to declining margins and rising leverage.

Current Ratio The current ratio is a liquidity ratio that measures a company’s ability to pay short-term and long-term obligations. To gauge this ability, the current ratio considers the total assets of a company (both liquid and illiquid) relative to that company’s total liabilities.

Quick Ratio The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.

Levered Cash Flows The free cash flow that remains after a company has paid its obligations on its debt. The levered cash flow represents the amount of cash left over for stockholders and for investment after all obligations are covered. The levered cash flow can be negative while the operating cash flow is positive if the amount of cash paid to cover obligations exceeds the cash that comes from operations.

Portfolio Update

As noted above, I reviewed our portfolio holdings using Global Income Edge’s proprietary Early Warning System. Typically, when a firm has two quarters of negative return on equity, the firm is a candidate for a Sell rating, for example. 

While some of our holdings did experience two quarters of negative ROE in the last year, they all rebounded, and I’m pleased to report that our holdings in the Conservative, Aggressive and REIT portfolios have, on balance, been strong from an ROE standpoint.   

The other result to note is that while there has been much share price volatility in the Aggressive Portfolio, due to the slowing global economy, and in the REIT Portfolio, as rate hike fears caused a selloff, on balance the holdings’ fundamentals remain strong.  

In the upcoming February issue, I will provide a deep dive as to how all the firms compare according to the criteria that I applied. But here I share a few highlights from my initial analyses.

In the Conservative Portfolio, I have been impressed with telecom giant AT&T‘s (NYSE: T) ability to deliver consistent ROE of between 2.5% and 3.5% on net profit margins of between 8% and 10%. Further the firm has significant amounts of cash left over for stockholders and for investment after all obligations are covered.  T is a Buy up to $38

Also in the Conservative Portfolio, healthcare holding Merck & Co (NYSE: MRK) had a step-up in its ROE to 4% as a result of increased profitability, and the firm has exceeded expectations with respect to liquidity measures such as quick and current ratios, and with respect to how much cash is left over for stockholders and for investments after all obligations are covered. MRK is a Buy up to $65.    

In our Aggressive Portfolio, global engineering firm ABB (NYSE: ABB) also was a standout, which was particularly surprising given how battered its stock has been lately. The firm has shown several consistent quarters of ROE of between 3.7% and 4.1%. And when looking at its liquidity ratios (current and quick) the firm is more than capable of paying back its obligation. We also liked that there was a lot of cash left over to pat stockholders and for investments after all obligations are covered. ABB is a Buy up to $30.

In our REIT Portfolio, we continue to recommend as our #1 Best Buy, S&P Dividend Aristocrat HCP (NYSE: HCP), which has had a nice rebound in ROE from increases in net profit margin over the last two quarters.  HCP is a Buy up to $44.