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Ideas for investing in late-cycle markets

White Paper
23 July 2019

With global economies and markets looking increasingly late-cycle, we look at investment strategies that could perform well in this new environment. 

Just as the seasons follow a rhythmic cycle each year, so economies and markets move through well-defined stages of expansion, contraction, recession and recovery, oscillating between irrational exuberance and excessive pessimism. It is fair to say that investors have enjoyed a long summer since the Global Financial Crisis, with equity markets having recently passed the 10-year anniversary of their trough in March 2009. Bond investors have had it even better, basking in the warm glow of a bull market that has lasted over 35 years. Some argue that these benign conditions can continue for the foreseeable future, partly because a lack of inflationary pressure has enabled the Fed to make a dovish policy U-turn, bringing back the ‘Goldilocks’ conditions that allowed risk assets to soar in recent years. 

Without wishing to pour cold water over such optimism, this ignores the possibility that economic growth slows more sharply than anticipated, or that growth picks up again and the Fed is forced to continue raising rates. Consequently, the Goldilocks argument does not seem compelling in the medium term as it relies on the continuation of a very narrow set of circumstances. More fundamentally, with the US economic expansion now the longest on record, lofty valuations in most asset classes, elevated debt levels, and an inverted yield curve, the global economy and markets are now looking distinctly autumnal. 

In the event of a wintery downturn coming as soon as 2020, investors may wish to consider whether portfolios that have worked well in the good times remain correctly positioned for a more testing environment. For equities, these challenging conditions will almost certainly mean absolute returns are lower than they have been over the past decade. Meanwhile, greater divergence of returns between countries, sectors and stocks should benefit active managers, potentially showing passive investors the true cost of simply buying an index of yesterday’s winners. Beyond equities, as we have previously argued, a recession is likely to catalyse a sweeping downgrade in the corporate bond market. Consequently, many income hungry investors may be left wishing that they had placed more emphasis on balance sheet strength in their due diligence process. In the long-short world, there is likely to be a growing gulf between the winners and the losers, with long-biased funds struggling as we move through the cycle. That said, rising volatility should provide strong long-short managers with plenty of opportunities.

At the current stage in the cycle, we believe it is simply too late to have significant exposure to value equities, cyclical sectors and smaller-cap stocks. These areas of the market tend to perform best when macroeconomic momentum is strong and bond yields are rising. Just as it seems too late in the cycle to be heavily exposed to high-risk assets, we believe it is too early in the cycle to have significant exposure to low-risk assets such as cash and government bonds, particularly as monetary policy is likely to become more accommodative over the coming months. Thus, mid-risk assets such as high-quality equities seem to make the most sense at the present time. Indeed, these assets tend to perform best in a world of sustained low growth and low rates.

With this in mind, it may be worth considering our Global Equity strategy, which only invests in what we deem to be extremely high-quality companies. More specifically, when screening for stocks to consider for inclusion in the portfolio, we look for companies with at least 10 to 15 consecutive years of double digit cash flow return on investment. This length of time is designed to ensure that the companies have produced these returns over two business cycles, enduring at least one recession. Such a rigorous process helps us to objectively identify those rare companies that have found an invaluable formula for sustainably superior returns. Only about 600 companies in the world meet this stringent requirement. Companies that have achieved such impressive returns through the Global Financial Crisis have proved themselves to be extremely resilient. 

We then rank the resulting 600-stock universe based on valuation and momentum, weighted 60/40, respectively.  We apply a wide range of valuation metrics including discounted cash flow, P/E, P/B, EV/EBITDA, and free cash flow yield.  The lion’s share of our ideas come from the top quintile of this list. We then undertake detailed fundamental analysis to gauge the extent to which these superior returns and the conditions that support them can be maintained into the future. Here we are looking for businesses with clear competitive advantages such as powerful intellectual property, strong brands, and leading market positions through scale, network effects, or switching costs. We believe that these factors result in superior pricing power, higher returns on capital, and strong free cash flows. We expect these cash flows to be reinvested in order to grow the business and to enhance the existing competitive advantage. We also expect surplus cash to be returned to shareholders via dividends and share buybacks. This is where the quality of management and their incentivisation becomes important. In our view, the main task of a management team, apart from running operations smoothly and safely, is to make prudent capital allocation decisions and to ensure that a strong balance sheet is maintained. When excellent management is combined with the ability to keep competition at bay (due to factors such as brand strength, high barriers to entry, economies of scale, network effects, or high switching costs) then we have the ingredients for a company whose superior returns can be maintained for far longer than the market expects. As can be seen below, the result of our disciplined process is a concentrated portfolio of 30-40 high-quality, attractively valued companies that we believe should outperform at this stage in the cycle, as well as in the long run.

Current Global Portfolio Characteristics

Source: TT International, MSCI, DataStream, as at 30th June 2019

Markets are clearly confused about where we are in the economic cycle. Bond yields have fallen sharply as growth has disappointed and the yield curve has now inverted, yet tight credit spreads suggest that potential distress in corporate balance sheets is of little concern to investors. Similarly, the recent equity market rally suggests that the Fed’s dovish policy U-turn is more important to investors than slowing earnings growth. Investor sentiment therefore seems to be caught in a tug of war between slowing growth and easier monetary policy. Crucially, we expect weaker economic momentum to increasingly dominate the global narrative. This backdrop should be supportive for our Global Equity strategy, which owns what we deem to be truly world-class companies, with strong and sustainable competitive advantages, trading at reasonable valuations. 

Important Information: 

Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).

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