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Investing in a late cycle

03 May 2019

By Julien Lafargue, Head of Equity Strategy

In very uncertain macroeconomic times, investors often seek reassurance by sticking to “safer” assets. In the world of equities, “quality” stocks are usually seen as the preferred hideout in turbulent times.

The combination of high volatility in the fourth quarter of 2018 and worrying signs about the economic cycle (weakening leading indicators, inverted yield curve) has proven to be a supportive backdrop for quality stocks.

Indeed, one index tracking higher quality companies (more on that below), has outperformed the broader US market by close to 500 basis points in the last six months.

This begs the question: is this trend set to continue?

S and P 500 index

The short answer, in our view, would be along the lines of “yes but…”. Yes, because we believe that over the medium term, owning well run, growing companies is a better strategy than betting on those operating in challenged industries and exhibiting weaker fundamentals.

For this reason, in our first edition of Market Perspectives, we argued that one should favour quality stocks this late in the economic cycle. But we see two main caveats to this view.

First, if as we expect economic growth rebounds after a difficult first quarter, low(er) quality stocks could stage a short-term rebound, boosted by renewed investor optimism and light positioning.

Second, the perception of quality is highly subjective and may mean different things to different investors. A closer look at a couple of quality indices devised by two leading providers (MSCI and Standard & Poor’s) illustrates this point. MSCI defines quality as a combination of high return on equity (ROE), stable year-over-year earnings growth and low financial leverage.

On the other hand, S&P screens stocks based on ROE, accruals ratio and financial leverage. The result is that only six of the top ten holdings in each of these two indices overlap. Even more strikingly, the energy sector is completely excluded by MSCI while it represents 7% of the S&P’s index.

While we won’t debate here on the merits (or lack thereof) of these two distinct approaches, we think that looking at past financial performance may not be the best way to predict future results.

For example, a track record of low financial leverage may be a reliable indicator of a prudent approach to balance sheet management. However, it may also point to inefficiencies, especially when interest rates are likely to stay low. As there is no consensus or scientific way to assess quality, its performance will be hard to judge.

So what do we, at Barclays Private Bank, mean when we say that we favour quality?

First, because companies and the world they operate in change constantly, we believe that adopting a forward-looking, and active approach makes more sense than screen-based, passive options.

…focusing on a company’s ability to generate cash flow is more relevant than its leverage.

Second, we believe that quality is not a synonym for defensiveness. So we believe that cyclical sectors should not be excluded.

Lastly, from a more technical stand point, we believe that focusing on a company’s ability to generate cash flow is more relevant than its leverage in the current environment.

Market Perspectives April 2019

Market Perspectives May 2019

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