Quality

Why cashflow can be a kingmaker after the crunch

Clyde Rossouw explains why quality companies are resilient in tough times and may grow rapidly in recoveries

May 20, 2020

5 minutes

Clyde Rossouw explains why quality companies are resilient in tough times and may grow rapidly in recoveries
The case for quality investing — building a portfolio of companies with competitive advantages, strong market positions, healthy balance sheets, sustainable revenues and low sensitivity to the economic cycle — is obvious when markets are stormy.

Less discussed is the potential for quality companies to grow robustly in a recovering market. Amid the wreckage of weaker businesses as the dust settles, they often get a head start on growth that can propel them through the next cycle.

A key attribute that helps quality companies not only survive a downturn but continue to expand in the aftermath is their strong cash positions: or, more specifically, the fact they tend to be both cash-flow resilient and to have cash on hand (accessible cash). They say cash is king. After a crunch, possessing these twin cash advantages can be a kingmaker, helping quality businesses increase their market dominance. As we explore below, history suggests they have helped some quality companies outperform as a recovery gets underway.

What is a quality company?

Quality companies, as we define them, have five attributes, as shown in the figure.

What is a quality company

These characteristics help quality companies survive a market crisis and the slowdown that sometimes follows:

  • Whatever the economic backdrop, revenues usually keep flowing for quality companies — or, if extreme circumstances do interrupt them, the hiatus would be expected to be brief before structural growth resumes. This is partly because they offer products and services that people need, which may sometimes be sold via subscription or as recurring purchases. They also tend to operate in growing industries where they have competitive advantages. Consequently, they aren’t as vulnerable when the economy slows.
  • Because they often have dominant market positions, quality companies may have pricing power, which gives them additional protection in a downturn.
  • Quality companies tend to have low operating expenses, especially low fixed costs. They are also capital light, meaning they don’t need to spend a lot on maintaining, say, factories or sophisticated machinery just to stay in business.
  • Strong balance sheets are another feature of quality companies. As well as having relatively little debt, they typically have significant levels of cash and ready access to liquidity/funding on good terms, due to their strong credit ratings.

Together, these attributes give quality companies more flexibility in allocating capital (see figure below). As we suggested earlier, that’s an advantage not only in challenging times, but also when the storm passes.

Increased optionality

During a crunch, quality companies can make productive use of share buybacks or temporary dividend cuts to ensure they remain resilient and to prepare for a changed economic environment. That is to say, they can suspend buybacks if required as they have not been reliant on borrowing to buy back shares in order to drive earnings-pershare growth.

When conditions improve, they can spend on growing their businesses or on acquisitions — at what may be a very advantageous time to do so, as some weaker rivals may have been eliminated or may be available for purchase at a low price. With a clearer field, the potential for robust growth is higher, which is why quality companies can be quick out of the blocks in a recovery. They are also likely to restore dividends sooner, if they reduced them at all — something income-seeking investors will particularly appreciate.

Increased optionality

Simply put, after a shake-out, the strong tend to get stronger. The performance of Ninety One’s Global Franchise strategy — which seeks to identify quality companies through in-depth research — suggests as much, with generally above-benchmark returns in the year immediately after a market downturn, as shown in the figure below.

Annual performance in USD, %

Annual performance in USD, %

Past performance is not a reliable indicator of future results, losses may be made.
Source: Morningstar, 31 March 2020. Performance is net of fees (NAV based, including ongoing charges, excluding initial charges), gross income reinvested, in USD. Inception date 10.04.07. The performance is based on the OEIC Global Select Equity Fund from 10.04.07 which then merged into the Luxembourg-domiciled Global Franchise Fund on 04.06.09.
*Benchmark: At Inception = MSCI World NR; Current Since 1 Oct 2011 = MSCI AC World NR.
5 year performance record: 2015: Fund 9.2%; Index -2.4%. 2016: Fund 0.9%; Index 7.9%. 2017: Fund 24.9%; Index 24.0%. 2018: Fund -3.6%; Index -9.4%. 2019: Fund 28.2%; Index 26.6%. Highest and lowest returns achieved during a Rolling 12 month period since inception: Feb 2010: 54.4% and Feb 2009: -38.7%. The Fund is actively managed. Any index is shown for illustrative purposes only.

Valuations are key

Or course, those seeking to follow a quality investment style need to maintain valuation discipline, buying shares in quality companies at reasonable prices. With an active, research-intensive approach, that can be done at any time. But it is at times like the present, after largely indiscriminate sell-offs when share-price moves detach from fundamentals, that the opportunity to build a quality portfolio at low valuations is often the greatest.

And whether what follows the current turmoil is a prolonged slowdown or a swift bounce back, a quality portfolio’s combination of resilience in hard times and strong growth potential in recoveries could stand investors in good stead.

 

Download PDF

 

Specific risks:
Concentrated portfolio: The portfolio invests in a relatively small number of individual holdings. This may mean wider fluctuations in value than more broadly invested portfolios. A counterparty to a derivative transaction may fail to meet its obligations which may also lead to a financial loss.

Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company.

All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results.

Authored by

Clyde Rossouw

Co-Head of Quality

Emerging Market Debt Indicator April 2020

Our EM Fixed Income team summarises recent market developments across the EM sovereign debt universe. The team also shares its views on the outlook for EM debt and provides insights into portfolio positioning....

Important Information

This communication is provided for general information only should not be construed as advice.

All the information in is believed to be reliable but may be inaccurate or incomplete. The views are those of the contributor at the time of publication and do not necessary reflect those of Ninety One.

Any opinions stated are honestly held but are not guaranteed and should not be relied upon.

All rights reserved. Issued by Ninety One, issued April 2020.