Why quality companies are key in today’s late-cycle economy

As global economic growth slows, it can become more challenging to navigate the global equity market. Paul Boyne, lead portfolio manager our global equity strategy, explores the potential in companies with strong quality attributes that could enable these firms to hold up relatively well, should economic conditions weaken further.

During challenging market environments—when the macro outlook is weak, valuations questionable, and margins stretched—we believe high-quality companies possess strengths that enable them to distinguish themselves from their peers.

Although monetary policy easing supports economic growth and corporate profitability can drive asset price rallies in the long run, a late-cycle monetary expansion often coincides with an economic slowdown, from our experience. As we’ve seen so far in 2019, equity markets typically struggle in the early phase of easing, reflecting the weakening of fundamentals combined with elevated uncertainty and negative sentiment. In this challenging environment, we see select opportunities in attractively valued, quality companies with strong balance sheets that can offer the potential to not only withstand a downturn in the marketplace but also provide long-term capital appreciation.

The late-cycle slowdown

Today, investors should consider the reality that we’re in a slowing global economic environment. The U.S. Federal Reserve (Fed) took on a dovish stance at the beginning of 2019, leading to interest-rate cuts in July, September, and October. The August and September manufacturing index reports from the Institute for Supply Management signaled a contraction for the first time in three years, with the September figure dropping to the lowest level in 10 years.¹ In light of such data, it’s no surprise that negative sentiment has increased, in our view.

From our perspective, the more interesting trend is the growing number of company management teams that we’ve recently engaged with that reported they were preparing for a potential market downturn by conserving cash and delaying capital expenditures, even as they maintained operational stances geared toward a growth environment. This is where companies’ quality characteristics grow in importance as investors navigate through a global slowdown.

"Looking ahead, we believe that seeking higher-quality companies will be paramount in an environment of high debt, high profit margins, and declining operating cash flows."

Why quality matters

We define quality companies as those that can produce high returns on capital in excess of their cost of capital and, over time, can sustain and grow those returns. These quality companies are competitive and often have a commanding position in their respective market segments. They also possess proven track records for growing their returns on invested capital and have consistently performed well throughout successive stages of economic cycles. Although past performance isn’t indicative of future results, these companies can offer sustainable free cash flow growth and provide the potential for downside protection when the external environment deteriorates.

A strong balance sheet matters because heavy debt in a market downturn can put a company at risk of insolvency. When the global economy slows, revenue growth declines and profit margins decrease, leaving the company with less cash to pay debt obligations and to sustain the business. To potentially avoid such scenarios, quality companies avoid mixing operational leverage with financial leverage.

The current U.S. equity bull market—now more than a decade old—has been driven in part by leveraging financial engineering, which is logical, given the environment of low interest rates that emerged beginning in 2009. It makes sense that companies employed cheap sources of capital to boost their business; however, it’s important to note that some allocated their capital more wisely than others. Looking ahead, we believe that seeking higher-quality companies will be paramount in an environment of high debt, high profit margins, and declining operating cash flows.

Profit margins have already peaked, in our view, and we expect that companies in general will have an increasingly tougher time lifting those margins.

Chart showing earnings before interest, tax, depreciation, and amortization, or EBITDA, for stocks in the MSCI World Index, January 2005-January 2019. The chart shows that as of October 2019,  EBITDA for global stocks are at its highest levels since 2005.

Another warning sign that we see is the growth in nonfinancial corporate sector debt, which has climbed to record levels² —a trend that may put some companies in a vulnerable position as the global economy slows.

Chart of U.S. corporate debt in trillions of dollars, excluding the financials sector, March 2005-March 2019. The chart shows that leverage levels among U.S. firms, excluding the financials sector, are near record levels.

Another source of potential pressure is the long decline in operating cash flow as a percentage of reported earnings.³ This decline has left U.S. companies in general with less cash on hand to pay down debt obligations and sustain a potential market downturn.

Chart showing operating cashflow as a percentage of net profits for companies in the MSCI USA Index, 1995-2018. The chart shows that operating cash flow among constituent companies of the MSCI USA Index have been falling since 2015, and is currently at low levels not seen since 2011.

Where’s the value?

Quality can be a positive attribute when it comes to protecting capital, and investing in quality companies at a discount to their fair value can be critical to generating strong long-term capital appreciation. In our view, valuations today are at extremes—not only in terms of the divergence of price-to-earnings between growth and value equity styles, but also that growth stocks have recently traded at their highest valuations since the end of the dot-com bubble in 2002.⁴ Maintaining a value tilt in a portfolio may be prudent going forward, in our view.

Chart showing forward price-to-earnings ratios for the S&P 500 Growth Index versus the S&P 500 Value Index. The chart shows that as of July 2019, the forward price-earnings ratio for the S&P 500 Growth Index has climbed back to highs not seen since around the dotcom bubble. Separately, the gap between the S&P 500 Growth Index and the S&P 500 Value Index has widened.

We’re also seeing valuation extremes from a geographic standpoint. Largely driven by growth expansion—particularly in the large-cap technology space—the U.S. equity market has recently traded at significantly higher valuations than the rest of the developed world. To highlight the extreme nature of the divergence, the MSCI EAFE Index has recently traded near a 31-year low relative to the MSCI USA Index.⁵

Chart showing trailing price-to-earnings ratios for the MSCI Europe, Australasia and Fast East Index versus the MSCI USA Index from October 2004- to September 2019. The chart shows that the valuation gap between the two indexes has widened in the last five years. The trailing price-to-earnings ratio for MSCI USA index stood at around 20 times as of September 2019, while the equivalent ratio for the MSCI Europe, Australasia and the Far East was closer to 15 times at that date.

The importance of quality with a valuation focus—and a global opportunity set

During challenging market environments—when the macro outlook is weak, valuations questionable, and margins stretched—we believe high-quality companies possess strengths that enable them to distinguish themselves from their peers. Over the long term, quality investing with an intrinsic valuation focus is generally a solid investment choice—not only for potential capital appreciation, but for providing potential capital protection, particularly in down markets. However, it’s important to note that quality alone doesn’t offer the potential to protect total returns; rather, paying the right price for that quality can be key to potentially generate strong long-term risk-adjusted returns, in our view. That is why it can be beneficial to invest in a global portfolio that has the flexibility to seek the best valuation opportunities across geographies.

In comparing U.S. equities with non-U.S. developed markets, the U.S. market has recently traded near a 15-year peak relative multiple versus international markets.⁶ While we view international profitability as cyclically high, it remains well below its American equivalent, on average. As a result, the greatest potential value that we see is in international markets—largely in quality companies with global operations. Despite value equities’ performance edge over their growth counterparts during September, value stocks have continued to trade at a substantial discount to growth stocks, in our view. In aggregate, we believe a portfolio is appropriately positioned for strong relative performance if it retains a higher level of profitability as well as lower debt levels and trades at multiples that are cheaper than those of its global peers.

 

 

1 September 2019 Manufacturing ISM® Report On Business, Institute for Supply Management, October 1, 2019. 2 International Monetary Fund, 2019. 3 Jefferies Group, FactSet, September 2019. 4 FactSet, 2019. 5  FactSet, October 2019. It is not possible to invest directly in an index. 6 FactSet, October 2019.

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Paul G. Boyne

Paul G. Boyne , 

Senior Portfolio Manager, Global Equity

Manulife Investment Management

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