• Intense pressure from global debt and economic challenges will almost certainly keep equity market volatility elevated in 2013.

• Many businesses have reached their cost-cutting limits. But the “diamonds” have strong balance sheets, sustainable cash flows and innovative products.

• A key strategy in this environment is to buy attractive businesses during periods when they are valued homogenously, such as during spikes in market correlation.

 “No pressure, no diamonds” – Essayist Thomas Carlyle

As we enter 2013 and consider the opportunities for investing in the equity markets, there is certainly no shortage of challenges. Global growth remains subpar overall. Developed nations of the world face massive debt loads and fiscal imbalances, which demand they take difficult actions. The developing nations that had been in the vanguard of global growth, most notably China, have become vulnerable to slowing in their end markets. Even the U.S. corporate profit engine, which has driven remarkably consistent bottom-line advances despite increasingly paltry revenue growth, seems to be running low of opportunity for margin improvement.

Nevertheless, there are bright spots to the outlook for equity investors, including modest expectations, marked by low multiples on earnings and cash flow in absolute terms, particularly against a backdrop of extremely low interest rates. And, there are pockets of strength and standout innovation throughout the global economy.

Intense pressure from the global backdrop will almost certainly keep market volatility elevated. However, a fearful market supported by very aggressive monetary policy creates an environment where any incremental relief from that pressure may result in significant gains. In this environment, diamonds — that is, investment opportunities — can emerge from the pressure. Specifically, we look for fundamentally distinctive companies supported by innovation along with significant returns of cash flow to shareholders. We also look to take advantage of the inevitable surges in market fear by adding to positions where we have high conviction.

Looking back on 2012, it was a saw-tooth market alternating between fear and relief as disappointing earnings and continued monetary stimulus battled it out for control of the market’s direction. Cross-correlation also gyrated through the year, with all S&P 500 stocks moving in generally the same direction when fear spiked, before following their own distinct fundamental paths as the dust settled and markets calmed.

Our core belief is that, while security cross-correlations will likely remain volatile during this period of global macroeconomic uncertainty, the fortunes of companies within similar global industries will increasingly diverge from each other. In reaction to the 2008 financial crisis, corporations around the world, led by those in the U.S., tightened their belts and reduced expenditures. As a result, the profit rebound from 2008 lows has been impressive.

However, there is a cost to throttling back reinvestment. Many businesses have significantly diminished or delayed employee training, research and development, and the implementation of cutting-edge technology. As a result, incremental organic revenue growth is suffering.

Therefore, when expectations and valuations appear reasonable, we favor resilient businesses over those that have less control over their own destiny, particularly those that have played all of their cost-cutting cards. What types of companies have the flexibility to determine their own longer-term fortunes? In our view, they are companies that have some combination of the following:

• Strong balance sheets
• Sustainably high free cash flows
• Organic sources of revenue growth, such as product innovation
• Deep global competitive advantages 

That may sound like an all-weather quality bias that could lead an investor to ignore premium valuations that usually accompany such situations. The key to this strategy is to buy attractive businesses during periods when they are valued homogenously, such as during spikes in market correlation. Indeed, competitively advantaged businesses exist in volatile geographies and industries. The key to outperforming in these risk-on/risk-off markets may well be to buy those businesses when the backdrop looks dire and then hold them as they regain the premium valuations they deserve.

Although volatile risk premiums seem to be the new normal, they may offer disciplined stock selectors an attractive way to add value by revealing the diamonds.

For an in-depth look at equity investing in 2013, read our 2013 Perspectives.

See more Market Insights from Columbia Management.