In our 3rd Quarter Northstar Market Report Rachel and I discuss investing styles and how these perform within different economic cycles. We provide insights into where we believe the current global economic cycle is at and why our approach of owning underpriced quality companies is safe for our clients. Marco and Simphiwe cover Vodacom, emphasizing the stability of the firm while Rory takes us back to the 3rd quarter of 2017, when we believed Apple was underpriced and how our view, after the stratospheric rise in the share price, has now changed. John Steenhuisen writes about the 2019 elections with a crisp reality check and we conclude by introducing one of our senior analysts, Andrew Randles.
Defining the various styles
There are many investing styles. To recognise a style, one can look at the factors an investor considers key before allocating capital to an opportunity.
Typical styles include ‘value’ where the dominant requirement would be companies that can be bought below replacement value, in other words companies are sought that are priced on the market at less than what it would cost to rebuild these businesses. Another is ‘growth’ and by definition, growth investors gravitate around growth factors such as sales and earnings growth with less emphasis on how expensive the company is today.
A third is ‘momentum’, a style diametrically opposed to Buffett’s concept that investing is about buying into a real living business. Momentum places little to no value on the business credentials of a company but focuses instead on share price movements. These investors want to own companies with rising share prices and avoid those where prices are flaying.
The final main stream style which you will hear about is ‘quality’. Traditional quality money managers seek companies that have low levels of debt, have stable annual levels of profitability and have a history of delivering excellent returns to their stakeholders.
Northstar uses the best of quality and value
Northstar has always centered its approach on quality but with a critical tweak – ‘Quality at a reasonable price’. We have ascertained that the above styles have attributes which, if blended cleverly, produce better results than their stand-alone performances. Northstar will never buy into a low quality business, which is typical of a value manager. We will also never be drawn into owning a quality company that is over-priced. Our approach is one of finding quality companies that are underpriced.
Styles and economic cycles
With the definitions behind us, the balance of this article is dedicated to Northstar’s research conducted on the performance of the value style versus the quality style in varying economic climates. We finally conclude with a stab at where we think we are in the global economic cycle.
We have divided a typical economic cycle (Table 1, over page) into four underlying seasons – recession, recovery, expansion and slowdown. Against this, we have shown how each style has performed historically during these economic seasons. The following are our observations:
- There is a strong relationship between the performance of value companies and improving economic conditions.
- We believe this occurs because weak (value) companies require macro-economic conditions to drive their profit levels rather than their own core internal strengths. As an example, commodity companies are price takers and do well in a pickup in global growth.
- Value stocks are generally, in our opinion, lower quality businesses requiring a larger risk appetite if acquired. Risk taking is higher in economic upswings.
- Quality does significantly better in recessions and periods of slowdown. Profitability in these companies is more dependable due to their economic moats and they are less cycle dependent.
- Quality businesses generally have fortified balance sheets. They are simply less risky and in risk averse climates, investors seek solace in them.
Table 1. Investment styles and economic cycles. Source: OECD (2018), Composite leading indicator (CLI) (indicator). doi: 10.1787/4a174487-en (Accessed on 06 September 2018).
Where are we in the economic cycle?
We believe we are nearing a slowdown in the economic cycle. Our reasoning for this is highly detailed but in broad terms:
- Monetary and fiscal expansion has been the agenda of most governments since the 2008 global financial crisis and in the most part, this has now been achieved.
- Central banks are now raising interest rates and yield curves are flattening, indicating a slowdown.
- The US economy is at full employment and the Federal Reserve Bank (Fed) is determined not to be behind the curve. The Fed is the global default interest rate setter.
- Inflation is rearing its head in pockets and central banks are responding to this.
- Some leading indicators are pointing to a slowdown ahead.
Should history repeat itself, quality will outperform value if our contention of an economic slowing materializes. However, many quality companies have become very expensive with concomitant risk of capital loss. Consequently, the most sustainable and profitable investment destination for our clients will be quality companies, which we identify as underpriced. Quality at a reasonable price rather than quality at any price remains our core proposition in all economic climates.