Buy shares of only the strongest companies to make money in 2023, including ‘the kings of cash flow,’ says this five-star fund manager

The worst may be over for the stock market for this cycle, but many economists see more pain ahead for 2023, including a possible recession that will create poor financial-performance comparisons for companies and send stock prices even lower.

Greg Adams, director of quantitative and risk management at fund manager Alger, recommends that investors focus on companies with solid balance sheets and strong cash flow to endure tough times.

Alger is based in New York and has $26 billion in assets under management. Adams manages the $265 million Alger Growth & Income Fund AGIZX, which is rated five stars for its Class Z shares (the highest rating) by Morningstar, within the financial-information firm’s “Large Blend” category. There is more about the fund’s performance below.

Three categories of companies to choose from

During an interview, Adams said investors in this market have an opportunity to “expand their opportunity set” while lowering risk by focusing on companies that generate high levels of free cash flow — remaining cash flow after capital spending.

This is money that companies can use to pay or raise dividends, buy back shares (which, if done in sufficient quantities, can raise earnings per share and support higher stock prices), expand organically or through acquisitions, or for other corporate purposes.

The Alger Growth & Income Fund doesn’t limit itself to stocks of companies that pay dividends, but Adams explained that one of his objectives is to run a portfolio with an aggregate dividend yield that is about 1.4 times the S&P 500’s SPX weighted dividend yield, which is 1.76%, according to FactSet.

When selecting stocks for the fund, Adams said he and Alger’s research staff identify companies with low debt relative to enterprise value, with interest payments that can be covered easily with cash flow. They place selected companies into three categories:

• Dividend leaders — These are companies with dividend yields well above that of the S&P 500. Verizon Communications Inc. VZ is an example, with a dividend yield of 6.80%. Adams stressed that his analysis encompasses “free cash flow after the dividend payment.”
• Dividend growers — These companies “are growing the dividend at a nice rate, or they may have consistently grown it for years and years, even if the [current] dividend rate is not high,” Adams said. An example is Home Depot Inc. HD, which has a dividend yield of 2.38%, and has been raising its annual payouts “in the low- to mid-teens year after year,” he said.
• “Kings of cash flow” — In the interview, Adams said he uses this name for a category of companies that generate high levels of free cash flow whose stocks are attractively priced. He said Apple Inc. AAPL, the fund’s largest holding as of Sept. 30, was in this category before it began paying dividends in 2012. Alphabet Inc. GOOG   GOOGL is an example of a company that is in this category currently.

“There are often companies that could fit in any of the buckets,” Adams said.

Three stocks held by the Alger Growth & Income Fund

Shares of AbbVie Inc. ABBV have risen 20% this year, excluding dividends, but Adams still sees “reasonable upside” for the stock. The dividend yield is 3.65%.

Adams said some investors have been worried about generic competition for AbbVie’s Humira medication to treat arthritis. Still, sales are increasing for some of its other arthritis medications, he said. Adams also said AbbVie’s anti-wrinkle medication Botox “has maintained market share pretty well.”

Home Depot has taken a 23% tumble this year as rising interest rates have caused the U.S. housing market to fizzle. “It will be a tougher environment for Home Depot, but given the pullback for the stock, we see reasonable upside,” Adams said. He added that people will continue to spend to maintain or upgrade their homes.

Alphabet’s Class A shares are down 38% this year, which Adams said has reflected “the compression of valuations for growth names” and a decline in advertising spending. But he believes the company is well-positioned for the long term because of the ubiquity of its cloud services in the corporate environment.

Top holdings of the fund

Here are the top 10 holdings (of 76) of the Alger Growth & Income Fund as of Sept. 30 — this is actually a list of nine companies, because the fund holds Alphabet’s Class A and Class C shares.

Click on the tickers for more about each company. Read Tomi Kilgore’s detailed guide to the wealth of information for free on the MarketWatch quote page.

Fund performance

Here’s a comparison of 2021 returns and average annual returns through Dec. 21 for various periods between the fund, the S&P 500 and Morningstar’s Large Blend fund category:

Don’t miss: Tesla’s stock drop has been bad. But this company has wiped out more investor wealth in 2022.