Should quality company growth be highly valued in today’s abnormal cycle?

Good businesses are more expensive than they have been in the past, but ironically far more valuable in today’s world. The reason for this is simple. In a world bereft of growth opportunities, growth is priced at a premium. Normal cycles produce an abundance of economic growth, which is good for the performance of average businesses. They also create opportunities for higher company earnings. However, this cycle is far from normal and requires differentiated thinking to achieve meaningful returns, not a reliance on what has worked in the past.

In December 2008, as the world was gripped by the onset of the great recession, US 10-year bond yields fell to 2.12% – a low not seen for more than 70 years. At that time very few grasped the deflationary risks the world was facing, apart from perhaps central bankers studying the Great Depression. Now, more than eight years on, despite higher stock markets, we still have a term lending rate to the US government of 2.03%. 

So why have yields remained so low when the world is in recovery mode? This question has been perplexing economists and has occupied the brightest minds. Part of the riddle might be better understood if the message from the current commodity price landscape is considered, with oil prices at levels last seen in 2008. We believe low commodity prices and low bond yields confirm depressed levels of economic activity at a macro level, paired with intrinsic business model risk at the asset level.

Opportunity in resources shares?

Commodity companies compete only on price. They are currently not generating sufficient cashflow to cover their capital spending plans to maintain assets. This requires them to either shrink their operations or to cut costs. Sometimes cutting high cost mines produces diseconomies of scale, as in the platinum sector, where declining smelting throughput raises unit costs.

Most commodity companies are acting rationally at a micro level, but this behaviour in aggregate is lowering the overall cost curves at a macro level without improving firm-relative prospects. Highly financially leveraged businesses require further equity funding or face closure or business rescue. Cutting production has devastating social and governmental impact and is considered a last resort. This all means the down cycle will last longer than previously expected if higher demand does not return. Barriers to exit are high. Despite years of relative underperformance from resource shares, we do not think there is substantial opportunity to invest yet.

What should an asset allocator do?

If the Federal Reserve is unwilling to raise interest rates from near zero, should one consider investing in growth assets if there is no meaningful growth? Quality businesses are more likely to produce consistent levels of growth during times of economic uncertainty. We prefer quality equities that:

Provide compelling value: When we analysed global capital flows, it was evident that there has not been much new investment in quality equity strategies over the past 12 months, and this encourages us. Despite our strategies delivering strong performance, we still see compelling value in owning a portfolio of businesses on a free cash flow yield in excess of 5.7%, growing high single digits, with no leverage, and paying out 75% of the cash produced.

Manage their businesses for different trading environments: Stable cash generating businesses in consolidated industries have the ability to manage their pricing structures better than other industries. They can also cut costs through optimising distribution and marketing, paving the way for higher margins when markets are performing well, or protecting their cash flows when economic times are not as good.

Are likely to become more active in M&A: South African Breweries is a good example. Our strategies have enjoyed a value uplift from the proposal from Anheuser-Busch InBev. However, if we look at the deal multiples paid on this acquisition, it would suggest our portfolio is around 50% below fair value on similar terms. As such, we would expect more of these corporate deals to occur.