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

Equity | November 8, 2019

Paul Boyne, Lead Portfolio Manager, Global Equity Strategy

As global economic growth slows, it can become more challenging to navigate the global equity market. In this investment note, 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.

Our view: 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.

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.

Time may be running out for the 15-year global trend of rising profit margins
Profit margins as measured by earnings before interest, tax, depreciation, and amortization for stocks in the MSCI World Index, January 2005-January 2019 (%)

Source: FactSet, October 2019. Earnings before interest, tax, depreciation, and amortization (EBITDA) is a measure of a company's profitability that excludes expenses from interest and income tax payments. The MSCI World Index tracks the performance of publicly traded large- and mid-cap stocks of developed-market companies. It is not possible to invest directly in an index.

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.

The rise in U.S. corporate debt could pose risks as economic growth slows
U.S. corporate debt in trillions of dollars, excluding the financials sector, March 2005-March 2019

Source: Bloomberg, Inc., International Monetary Fund, 2019.

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.

With less cash to pay down debt, many U.S. companies have become vulnerable
Operating cashflow as a percentage of net profits for companies in the MSCI USA Index, 1995-2018 (%)

Source: Jefferies Group, FactSet, October 2019. The MSCI USA Index tracks the performance of publicly traded large- and mid-cap stocks of the U.S. market. It is not possible to invest directly in an index.

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.

The valuation gap between growth and value has widened in recent years
Forward price-to-earnings ratios for the S&P 500 Growth Index versus the S&P 500 Value Index, September 1995-July 2019

Source: FactSet, October 2019. A forward price-to-earnings (P/E) ratio is a stock valuation measure comparing the current share price of a stock with the underlying company's estimated earnings per share over the next 12 months. The S&P 500 Growth Index tracks the performance of companies in the S&P 500 Index that are categorized as growth stocks based on measurements of their sales growth, earnings change to price, and momentum characteristics relative to other companies in the index. The S&P 500 Value Index tracks the performance of companies in the S&P 500 Index that are categorized as value stocks based on measurements of their price-to-book rations, earnings, and sales to price relative to other companies in the index. It is not possible to invest directly in an index.

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

The valuation gap between U.S. and ex-U.S. developed markets has expanded in recent years
Trailing price-to-earnings ratios for the MSCI EAFE Index versus the MSCI USA Index, October 2004-September 2019

Source: FactSet, October 2019. Trailing price-to-earnings (P/E) ratios measure a company's current stock price as multiple of its trailing 12-month earnings. The MSCI Europe, Australiasia, and Far East (EAFE) Index tracks the performance of publicly traded large- and mid-cap stocks of companies in those regions. The MSCI USA Index tracks the performance of publicly traded large- and mid-cap stocks of the U.S. market. It is not possible to invest directly in an index.

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.

1September 2019 Manufacturing ISM® Report On Business, Institute for Supply Management, 10/1/19.
2 International Monetary Fund, 2019.
3 Jefferies Group, FactSet, 2019.
4 FactSet, 2019.
5 FactSet, October 2019. It is not possible to invest directly in an index.
6 6 FactSet, October 2019.
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About the Author

2015 March Boyne Paul Paul Boyne

Lead Portfolio Manager, Global Equity Strategy

The opinions expressed are those of Manulife Asset Management™ at the time of publication, and are subject to change based on market and other conditions. The information in this article including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Asset Management disclaims any responsibility to update such information. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife Financial, Manulife Asset Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute an offer or an invitation by or on behalf of Manulife Asset Management to any person to buy or sell any security and is no indication of trading intent in any fund or account managed by Manulife Asset Management.

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