Why it’s time to focus on quality businesses

In 1976, US economist, Herbert Stein, famously stated that “If something cannot go on forever, it will stop.” His observation could well be applied to the ballooning value of many technology companies, some of which have never made a profit, and possibly never will. Which is why this might be a good time to look at high quality businesses that have been left behind by the rally.

Notwithstanding the lockdowns, infections and tragically unnecessary deaths in Victoria, the global investing news flow in recent weeks has been relatively positive. The Europeans agreed on a stimulus package and the news on the progress of a vaccine has been encouraging. It should have been very, very good news for the stock market, especially for cyclical and value stocks (those that have not participated in the technology bubble).

Much of the strength in the stock market since the March lows has been driven or led by technology companies. Don’t get me wrong – some are amazing businesses, they enjoy monopoly pricing power, tailwinds and long runways for growth. In an environment where returns are very low, investors are right to seek high quality growth, and that is what these companies represent.

But the prices being paid for these companies reflect an enthusiasm that has become detached from reality. Moreover, the strength in the share prices for these companies is disguising a more challenged outlook for listed companies and the economy.

Just what will the future outlook present

At the same time, we observe these extreme market multiples we are also seeing unsustainably low levels of volatility. And volatility is beholden to vaccine, fiscal and monetary policy success. Too much has to go right for volatility not to spike again along with the equity market risk premium.

Now could be the time to be rebalancing portfolios towards the highest quality company names that have been left behind by the rally. A somewhat contrarian view is to consider listed securities that have a stake in high quality assets, those with genuine leverage to a vaccine while also benefitting from a continuation of lower interest rates. That might mean airports, shopping centres and toll roads. The strategy of course is not without risk, but neither is owning highly priced technology bubble stocks.

The US Federal Reserve has expanded its balance sheet by US$3 trillion, or as much as 70 per cent, since the beginning of 2020. The US Fed has also announced that it will provide unlimited quantitative easing (QE) assuring investors that there will be ample.

Of course, the primary aim of increasing market liquidity, primarily by buying corporate bonds, is to reduce the incidence of highly indebted firms declaring bankruptcy.

But here’s the problem: companies are declaring bankruptcy on an increasing, rather than declining basis. In December 2019 less than US$20 billion in face value of non-financial corporate bonds defaulted. In April the number was about the same. In June however more than US$95 billion of bonds issued by non-financial corporates defaulted. And according to famed finance professor emeritus at New York University’s Stern School of Business and creator of the Z score, Edward Altman, the number of bankruptcies in 2020 will challenge the record number seen after the 2008 economic crisis.

By itself the level of bond defaults is miniscule compared to the size of bond markets and therefore inconsequential, but the defaults speak to the ineffectiveness of central bank policy in shoring up the economy against its entrenched problems.

Low rates are great if people spend and businesses invest, but that isn’t happening

There is so much liquidity in the Australian banking system that banks no longer have to borrow and consequently short-term rates are lower than the RBA official cash rate. But banks seem to have forgotten how to lend responsibly, and/or nobody wants to borrow and take risk.

Whichever is the case, the hoped-for stimulus and default-preventing that low rates and central bank unconventional monetary policy is supposed to provide isn’t working. And if central bank policy is ineffective in terms of its economic impact, how much should it be relied upon to suppress volatility? Sure, central banks don’t go broke, but they can run out of effectiveness and volatility can return.

Meanwhile the stock market hovers around all-time highs. One cannot help but wonder, if those we are relying on to save us, cannot, will stock market sentiment shift, at some point, from unbridled enthusiasm to despair.

I cannot say if or when sentiment will change; predicting the madness of crowds and the end of a popular delusion is next to impossible. What is true however is that it can shift overnight and without warning.

For that reason, it might be wise to rebalance portfolios. That interest rates remain low for a very long time is a reason to remain invested in equities. Equities represent the growth engine of a portfolio and so it is vital to remain invested with exposure reflecting one’s risk appetite. But rebalancing the portfolio from the riskiest of securities to something representing high quality may now make sense.

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