Where can you find quality in today's market? Tony DeSpirito shares his ideas.
Ninety years on from the Wall Street Crash, investors across the US and globally have learned to apply a cautiously optimistic approach to investing. After a period of continued share price growth, it was easy to believe that it could continue forever. When the Depression struck, many were caught out by not a having a strategy in place to succeed in a severe market downturn.
Today, as the economic and business cycles mature, we believe that a focus on quality should improve portfolio resilience. Alongside a robust dividend stream, it should help provide some level of protection against significant volatility, helping to create a smoother ride. Companies displaying quality characteristics such as strength in their balance sheets and free cash flow are better able to weather such bouts.
The Chicago Board Options Exchange Volatility Index, known as the VIX, is a common measure of stock market volatility in the S&P 500. It rose from lows of 12 in late July this year to over 20 for much of September and October. This type of volatility is commonplace at the end of a business cycle, when economic indicators are looking weaker and investors start to worry that corporate earnings will deteriorate.
Targeting quality stocks seems like a no-brainer. Why would anyone want to own part of a poor-quality company, particularly if cost were not a prohibitive factor? However, excitement over short-term revenue growth or, in contrast, excessive concern over short-term weakness, can blind investors to enduring quality companies.
Of course, if quality performed only in difficult markets, it wouldn’t necessarily be a good option. Stock markets go up more often than they go down. We find that quality stocks may forfeit some incremental return in big market bounces, but history suggests that they also are likely to lose less in the inevitable falls. This, on a net basis, makes them better investments over the course of a full cycle, we believe.
An all-weather option
Quality tends to underperform in sharply rising markets, such as when the economy is coming out of a recession. At these times, riskier lower-quality companies with higher leverage tend to outperform as they surge from their beaten-down state. However, that is not where we are today.
The fact that the economy has already been growing for some time, that markets are being rocked by US/China trade noise, plus the vagaries of an election cycle tells me that we may be in for a continued period of heightened volatility. A focus on quality stocks can allow investors to stay in the market to benefit from potential upturns, but with a measure of prudence built into buffer downturns.
Markers of quality
Most investors will recognise quality when they see it – reliable earnings, the ability and willingness to grow a dividend, a disciplined and prudent management team. By then, however, it’s often in the price of the shares. It’s much harder to identify quality ahead of broader market, to know what price to pay for it, and how to predict its durability.
Where can you find quality in today’s market? Two areas are scoring well on our quality screens: healthcare and technology.
An increasing number of constituents in the tech sector are what we refer to as “industrial tech”. These firms are competitively insulated from disruptors, well-positioned to take advantage of long-term secular tailwinds, and exhibit growth in earnings and free cash flow.
A swelling number of companies in the sector have also adopted dividend payments to shareholders as a viable use of cash, rejecting the notion that IT firms can add value to investors only via their growth potential. We believe that this trend is poised to continue, as many mature IT companies are flush with cash and shareholders are increasingly willing to reward management teams for return of capital.
Long-term growth opportunities in healthcare are a by-product of demographic trends. Older populations spend more on healthcare than younger populations and ageing demographics is a global trend. In the US, a combination of greater demand for healthcare services and rising costs drive a need for increased efficiency within the healthcare ecosystem. We believe that innovation and strong cost control can work hand-in-hand to address this need and companies that can contribute in this regard may be poised to benefit.
On the innovation front, there is a need for newer and more effective medicines and therapies. The U.S. Food and Drug Administration has made this a priority by increasing the volume and speed of drug approvals, which bodes well for pharmaceutical manufacturers that can deliver new drugs to the market.
There are plenty of reliable, quality businesses to be found operating across the US and globally, and finding these is as important today as it was 90 years ago, as we enter a rockier economic and market environment.
A keen focus on the attributes that mark high-quality companies can help ensure that history doesn’t repeat itself and help protect investors in the most severe of market downturns.
Tony DeSpirito is manager of the BlackRock North American Income Investment Trust.