Since the global financial crisis, we have seen loose monetary policy offer support to the corporate world, with record debt levels having built up indiscriminately as businesses have taken advantage of cheap borrowing. High growth stocks, bound by large amounts of leverage have enjoyed the heady heights of one-directional travel for almost a decade.
But things are starting to change.
In a downturn, we often see investors take the oft-cited “flight to quality”, and it’s easy to understand why. In more difficult market conditions, companies with stressed balance sheets, facing competitive pressures and struggling to capture new business have less room to breathe. Certain companies are simply cyclical in nature and (the better ones) learn to adapt to the ups and the downs over their lifetime.
Yet where Walter Scott, which manages both the BNY Mellon Long-Term Global Equity strategy and the Global Leaders strategy, and Newton, particularly with its Global Equity Income franchise, share some common ground, is in their shared preference for the long game.
A quest for quality
Walter Scott and Newton favour quality; even in rising markets, despite sacrificing some relative possible gains at the top end during very strong bull runs.
When a bull market comes to an end, the opportunity to find value stocks becomes prolific. But a long-term focus on high-quality, defensive growth stocks should not only deliver positive, steady returns over time but will also offer some downside protection in falling markets. Over a full market cycle, quality growth should offer/be a win-win.
So, what defines quality? Generally, quality companies will have strong balance sheets with low debt and high levels of free cash flow, resilient business models and consistent profitability, whose performance is agnostic to external market conditions. They might have high barriers to entry, so rivals are fewer and farther between and tend to demonstrate characteristics that are diametrically opposed to cheap ‘value’ stocks, whose business models may be vulnerable to a downturn or may be highly indebted. Both Walter Scott and Newton’s teams work hard to avoid falling into these ‘value traps’.
According to Walter Scott, there are seven key characteristics of global “leaders”. The team prefers to seek out the rare beasts with these characteristics focusing their attention on a smaller number of higher-quality holdings.
These seven traits are: pioneering; innovative; adaptable; differentiated; sustainable; visionary management; and with financial results that consistently stack up.
Our aim is for these characteristics to help global leaders create value over the long term. In the words of the investment team: “We are convinced that patiently investing in a highly select and focused portfolio of these companies, with due respect to valuation, should yield robust investment results over the long term.”
One such example held in the BNY Mellon Long-Term Global Equity strategy is TJX Companies. The parent company to formats including TJ Maxx and TK Maxx distributes discounted fashion and homeware. The company is well positioned to maintain steady growth over the long term, with the team praising its “buying power, compelling value proposition and the inherent flexibility of the business model”.
As the investment team stresses, quality does not mean sacrificing growth, but the pace and drivers of that growth will look quite different.
It says: “We have always cared about balance sheets and will not invest in imprudently leveraged companies. We have never believed that a healthy balance sheet equates with a lack of growth or opportunistic zeal.”
For Walter Scott, its qualitative criteria and quantitative hurdle rates are not dialled up or down depending on market conditions; they are consistently robust, and demanding.
With a more volatile ride perhaps for global equity markets the team remains upbeat: “We welcome the opportunity that might come to add to positions or invest in companies that have long been admired but precluded on valuation grounds.”
Split approaches, shared goals
Similarly, Newton recently took advantage of a dip in the share price of Richemont, bringing that Swiss luxury goods player – owner of several of the world’s leading luxury goods companies, including Cartier, Lange, IWC, Jaeger-LeCoultre and the recently acquired online fashion retailer Yoox Net-a-Porter – into the Global Equity Income portfolio.
The company’s shares performed badly in 2018, losing 35% from their May peak by the end of the year, which lead manager Nick Clay says was largely down to the decline in Chinese watch demand.
He adds: “We believe the market’s preoccupation with watches has meant the healthy majority of the business is underappreciated by investors. Within watches, the response has been for the company to repurchase inventories and cut revenue, which we think has provided an excellent investment opportunity, as we feel the company will reap the benefits of reducing sales, shoring up inventories and ultimately improving profitability.”
While a stable and rising dividend forms a cornerstone of Newton’s strategy, Clay’s dedication to seeking out yield-generators delivers more than just an income stream for his investors; he believes they can be a strong indicator of a company’s overall financial health.
“We regard a dividend as much more than merely a component of the overall return from a stock,” explains Clay. “It is tangible evidence of a firm’s profitability and represents a commitment by the management of a company to return the cash flow it generates to shareholders on a regular basis.”
With strong management and healthy balance sheet two of his quality indicators, one can quickly see the connection between income and long-term investment appeal – irrespective of whether an income stream is even the end objective.
Regular dividend payments align the interests of a company’s management to those of its shareholders, reflect management’s confidence in their company’s business model and also reduce the likelihood of a company over-gearing, while ensuring any cash on its balance sheet is put to sensible use.
With both strategies, patience is paramount. From Walter Scott looking for global leaders to Newton’s penchant for companies overlooked or underappreciated by the wider market: in each case the investment teams seek out quality with a view to delivering superior returns in both rising and falling markets.
The value of investments can fall. Investors may not get back the amount invested.