There’s nothing too predictable about the market’s trajectory in the short run, especially after a decade-long bull market. But we think there’s something predictable about high-quality companies: They can help an equity portfolio be braced to withstand volatile market change.
Is volatility set to rise?
To some, signs of rising volatility are looming over the markets. The yield curve’s repeated inversions seem to herald worsening economic conditions. Trade tensions between the United States and China as well as the European Union threaten to give way to more protracted conflict, upsetting long-term macroeconomic and geopolitical balances. And in our divisive political climate, the run-up to the 2020 presidential election could bring market-disruptive policy talk from both sides of the aisle.
While the foregoing elements feel plausible as drivers of future volatility, there’s no way to reliably model volatility’s future changes. That said, we believe there’s plenty of empirical evidence to show that volatility is a mean-reverting series. So, after our long period of unusually low volatility where it appears likely on a historical basis that volatility has troughed is when you might expect a reversion to higher levels of market turmoil to ensue.
What can investors do? Aim high for quality
To help insulate a portfolio from more turbulent conditions, we believe it’s important to focus on high business quality. Without it, investors risk capital disruption and permanent loss when market dislocations occur.
More than half the value of a company is derived from the future. To us, that means that understanding a company’s intrinsic value today requires having a good idea of its future earnings and cash flows. To get the best possible read on these future prospects, it helps if the company we’re trying to value is more predictable.
What makes a company more predictable?
In quantitative terms, we’re looking for companies that can generate high returns on invested capital, aren’t overburdened with debt, and demonstrate high earnings growth potential. We believe companies that score well on these quality metrics have an intangible quotient of predictability in their business model.
There are many ways a business can become more predictable, but recurring revenue is one of the most common characteristics. Consider enterprise software companies whose businesses run on long-term contracts, e-commerce companies that trade in consumables and subscription services, and consumer companies that foster ingrained consumer habits.
In the latter group, consider companies that are successful at driving consumer loyalty or that thrive on catering to legal addictions—need a morning coffee, anyone? Check your cell phone much? Companies operating efficiently in these spheres can see as much as 90% to 95% of their revenues recur in consistent patterns. The most robust predictable patterns are a key sign of quality.
Another avenue to predictability is pricing power, which means being able to control your margin destiny regardless of the state of the economy. To have that, you need a special product or service that can be priced at a premium or that's of comparable quality to competitors’ offerings and yet can be sold at a discount and enable you to take market share.
Several other items are important to us. Quality companies should have a long runway for growth with no intervening maturity wall, as well as strong financials—particularly robust cash flow generation and balance sheet strength. Last, we believe a talented management team is an essential component of a quality company, because talent and experience, in our view, are prerequisites for being a strong steward of capital.
Predictability converts volatility into opportunity
Once a critical mass of these elements of predictability is present in a company—and if its valuation isn’t too high—then we think it deserves being called a high-quality opportunity. However, sometimes these companies may simply be too expensive, in which case we have to wait for a resurgence of volatility to bring its valuation back to earth. Indeed, when major price swings occur, we're provided with two advantages to a quality-focused strategy:
1 Predictable companies tend to shine—When broad price swings amplify negative sentiment is frequently when the market becomes better at recognizing the attractiveness of predictable, resilient business models with recurring revenues, pricing power, robust financials, and strong management teams.
2 High-quality, higher-growth companies become more affordable—When volatility risesis when there's also a chance to buy high-quality growth stocks that had previously been valued out of reach. Volatility simply makes them affordable for a strategy that practices valuation discipline. We'll often trim or sell slower-growing, traditional, consistent growth companies when these opportunities arise and buy earlier lifecycle, higher-growth companies where the valuation has become more attractive amid market weakness.
Although volatility is undoubtedly uncomfortable for investors to endure, periods of higher volatility help generate more productive environments for quality-focused stock pickers. While we can’t model changes in market volatility with any degree of precision, we can rely on key high-quality business characteristics to help prepare a portfolio for volatility’s eventual return.