Business quality matters more than ever

2019 has seen share markets reach fresh highs after the Fed’s about-turn in monetary policy stance in January. This shift in market expectations from rate increases and quantitative tightening amid the drawdown of late 2018 to a lower for longer scenario has played out with the Fed cutting three times since.

This move has helped extend a multi-decade decline in long-term bond rates, itself a function of structural factors like high debt burdens, ageing populations and the deflationary impacts of technology adoption. All else equal, lower interest rates, and therefore discount rates, imply higher stock valuations as we’ve seen year to date.

What does this lower rate scenario imply however for economies overall? It reflects a broad slowdown in economic growth and proportionately lower forecast cash flows and in fact no net elevation in valuations!

But while it is a mistake to inflate all valuations with lower rates, it is equally important to distinguish which businesses are deserving of a valuation uplift coincident with lower rates… the companies where cash flows are resilient due to structural growth.

Structural growth can be driven by significant technology shifts like cloud computing and e-commerce or demographics such as the doubling of the Chinese middle class in the next 5-10 years or indeed the affluent class increasing 6-fold in the same time period. The key feature of this growth is that it is agnostic to economic circumstances or inflation rates.

Business quality matters in this context because quality provides confidence the company won’t befall disruption threats, quality helps determine which businesses will actually be positioned to benefit from these tailwinds we have identified and in the context of lower rates; quality provides conviction in the predictability of the cash flows a business will generate and therefore what it is worth.

Given the elevated prices we see today, Quality will prove key to navigating the uncertainties of 2020 and beyond. 

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This wire is part of the ‘One thing investors can’t ignore in 2020’ series. To download the full ebook please click here.

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Magellan was formed in 2006 by Hamish Douglass and Chris Mackay, two of Australia’s leading investment professionals. The company specialises in global equity and listed infrastructure assets.

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