As the economic cycle matures, investors may be looking for greater resilience in their portfolios. But co-manager of BlackRock North American Income Trust plc, Tony DeSpirito, discusses why traditional defensive investment strategies may not be the answer.
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There can be little doubt this economic cycle is reaching its later stages. We have had near uninterrupted expansion in the US stock market for more than a decade and the economy has seen a clean run of growth. While we see no imminent reason for a slowdown, it is best to be prepared.
But what does this look like today? This is not straightforward. Many of the old rules about how to invest more defensively do not apply. Moving into government bonds, for example, no longer looks like a particularly ‘safe’ strategy given the low yields on offer. The same is true for the stock market. Traditionally defensive areas look overpriced and may not provide the resilience a portfolio needs. In this environment, we believe it is vitally important to look at each company on its fundamentals, rather than succumb to broad-brush thinking on what should work in a maturing cycle.
The usual suspects
A natural choice for this stage in the market cycle might, for example, be areas such as real estate, consumer services and communications. But these areas have been caught up in the ‘bond proxy’ trade that has been so persistent for the past five years. ‘Bond proxies’ are where those companies with bond-like qualities have been adopted by investors moving out of fixed income into the stock market in search of higher yields. Prices are simply too high for these areas to act as a defensive option in a more difficult climate.
On the other hand, we are not tempted to compromise on quality in this environment, no matter how cheap share prices have become in certain segments of the market. Loose monetary policy has kept many companies afloat that might not otherwise have survived. Debt has proved a poisoned chalice in the current environment and vulnerable companies have quickly showed the strain. Many ‘cheap’ companies have become even cheaper and may continue to do so.
We want to be invested in those higher quality companies whose earnings we can reasonably forecast into the future. These companies are likely to be in a better position to weather the incoming storm. Today, we are finding more of those companies in the energy and financials sectors, despite these being seen as more ‘cyclical’ areas. We can also find companies that meet our criteria in the technology sector – though, admittedly, in niche subsectors rather than some of the expensive global technology giants. While we are both value, quality and income investors and technology does not usually fit the bill, investors need to look beyond those labels in today’s environment.
For any income strategy, it is important to be invested in companies that are generating income organically in this environment. Too often, companies are paying out more than they can realistically afford based on their earnings. This tactic leaves them particularly vulnerable in a weaker economic and market environment.
ISAs have a role in almost all portfolios, but they are particularly useful for income seekers. Unlike a pension, ISAs don’t offer tax relief on contributions made, but all income can be taken tax-free. This is a significant advantage at a time when interest rates are low and income scarce.
For us, particularly in the current climate, it is vitally important not only that a company can pay its dividends today, but that it can grow its dividends tomorrow. We base our judgment on cashflow; what is left for the shareholder when all a company’s other commitments have been paid. Good cash flow means the management team has been disciplined and that the company is likely to have competitive resilience.
In terms of how this looks in the portfolio, it means that the companies we hold are diverse – from large US banks to Microsoft – and they do not fit the natural assumptions about ‘quality’ or ‘defensive’ or ‘value’ stocks. It is what we see that is important, not the characteristics the market assigns to these stocks. This is a recognition that the world is changing – information technology can be the new consumer staple, for example. We believe this realistic appraisal of a company’s true merits will be vitally important as we move into a more challenging environment.
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