Managing the pitfalls of cyclicality

The current U.S. economic expansion has just become the longest on record. This period of uninterrupted growth has driven strong market performance over the past decade, but we believe has also increased risks to investors.

Aside from the complacency that is engendered by fading memories of the prior downturn, it actually gets more challenging – even for those who are mindful of the risks – to assess companies’ cyclical vulnerability since they have not been stress tested for a considerable period of time.

One of the most dangerous places to be caught in an economic downturn is holding companies whose earnings’ vulnerability is underestimated by the market. In this paper, we discuss our framework for managing that risk.

The value of predictability

While rapid earnings growth may seem appealing, the predictability of growth rates takes on greater importance as economic expansions slow.

Investors can reflect on lessons learned from the U.S. home building industry during the last downturn. Housing was booming, of course, during the years leading up to the 2008-09 crisis. Toll Brothers was a stock market darling as many Wall Street analysts confidently forecasted earnings would rise up to $6 a share as the financial crisis approached.

Home purchases are tied to interest rates and the state of the economy. Yet during the euphoria of the 2000’s, investors mistook Toll Brothers’ growth as driven by structural forces.

And, due to the cyclical nature of Toll Brothers’ earnings, it was impossible for analysts to accurately predict the magnitude of the downturn’s impact on the stock.

Meanwhile, more resilient stocks like Coca Cola provided investors with a different experience. Even though their earnings slowed, the magnitude of the impact was very modest. Therefore, the ultimate results were not that different from analysts' projections.

Avoiding pitfalls

Since we can not predict with accuracy when the next recession will occur, our approach for the Vontobel Quality Growth Funds is to be well positioned with our current holdings at all times. With that in mind, and in order to protect our investors, we do not invest in companies that we expect to be at risk of irreparable damage in an economic downturn. We aim to  avoid:

Not all growth is created equal

Some companies that have enjoyed robust growth driven by a combination of secular AND cyclical forces may present the greatest risk to investors. This matters because, in certain cases, it is difficult to separate how much of a company’s growth was due to a benign macro environment versus structural growth drivers that are unrelated to the state of the economy. These stocks may be the most dangerous because the economic sensitivity of a company’s earnings may turn out to be much greater than the market assumes.

Our framework for managing cyclicality

Growth driven by structural forces is sustainable

We focus on high quality companies with secular earnings growth drivers. This sustainable earnings growth drives consistent absolute returns and outperformance. In the example below, in the Vontobel Fund – U.S. Equity, earnings growth of our portfolio holdings exceeded the benchmark in recessionary times, and this consistent earnings growth also led to a greater compounding of earnings over the long term.

Growth, along with quality and price, is one of our main investment pillars. But not all growth is the same. Cyclical growth can be dangerous when the market turns. But cyclical growth masquerading as structural growth, with its associated higher valuation, can be disastrous.

As quality growth investors, we seek to avoid those  pitfalls by knowing what we own. This requires both being restrictive in defining our opportunity set and doing rigorous research on the select companies we consider  for investment.