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In Search of a Late-Cycle Buffer

With both earnings and multiples under pressure, the longest bull market in history is showing signs of weakness. Fortunately, strategies exist for sustainable late-cycle returns.

2019 has some curious echoes of 1999. Markets are surging, despite soggy earnings; U.S. employment data haven’t been this strong in decades and investors are once again swept up in an IPO frenzy. Even the Backstreet Boys are back. 

While compounders are a sound investment approach across the cycle… in our experience they have particular value when the cycle is coming to an end.

This may be more anecdotal than scientific, but it is all starting to feel rather late-cycle, characterized by pressure on profit margins, potentially followed by an economic downturn. Which is why we believe investors who haven’t yet done so should start considering a late-cycle buffer in a portfolio of equity compounders with sustainable high returns.

Such a portfolio boasts companies with strong pricing power, recurring revenues and limited need for credit. Companies like these are supported by difficult to replicate intangible assets, like strong franchise durability, customer loyalty, copyrights and distribution networks.

It's worth taking a moment to retrace how we got here. At the start of 2018, the team were worried about the elevated level of market multiples, that is the overall track of stock price-to-earnings ratios. By the end of the year, after a combination of a sharp derating and strong earnings increases, our primary worry had shifted to earnings.

But after strong returns so far in 2019, despite falling earnings, the narrative has shifted and we are now anxious about both multiples and earnings. 

Double Threat

The good news, as we like to say, is that there are only two ways to lose money in equities: If the earnings go away or if the multiple goes away. The bad news right now: Both are under threat.

The multiples are a concern because they have returned to September, 2018, levels, with the MSCI World Index close to 16X the next 12 months’ earnings,1 Some of the fears that stalked late 2018 have now faded, thanks to a start to Federal Reserve rate cuts to counter weaker growth, but the experience of last year’s two market swoons suggests significant downside risk to multiples ahead, even without a cyclical earnings shock.

As for earnings, our underlying anxiety is that they may be unsustainably high, particularly in the U.S. Margins are near peak levels, as are profits’ share of GDP and the level of leverage to boost earnings per share. Earnings are also drifting down, even as the market rises. The 2019 MSCI World Index earnings estimates are off 9% since the start of the fourth quarter, 2018, and are down 6.5% year to date.2 In the U.S., where quarterly data is available, earnings are actually expected to be down around 3% year-on-year after falls in Q1 and Q2.3

What’s interesting is the source of the U.S. earnings drop. Revenues are still healthy, expected to be up around 54% on the year,4 but profit margins are falling as costs rise in the U.S., notably for labor. Many companies are struggling to pass those higher costs on to their customers. The National Association of Business Economics reported in March 2019 that 58% of respondents said they faced higher labor costs, but only 19% had been able to raise prices, presumably those with the strongest pricing power.

The market, per usual, assumes that conditions will improve. Consensus expects U.S. earnings to be up nearly 10% year-on-year in 2020, despite the declines so far this year.5 This may be overly optimistic, given the late-cycle margin pressure, or the even-later-cycle economic downturn. 

Pricing Power

Compounders may offer investors some reduced downside participation through companies with recurring revenues and pricing power. The latter, rooted in powerful brands and networks, can protect margins as costs rise, while the revenues, from repeat purchases or long-term contracts, support the level of sales. The combination of robust sales and margins should help drive profits, particularly given limited operational or financial leverage.

While past performance doesn’t guarantee future outcomes, we believe that the impact of the 2008-09 global financial crisis supports our thesis that investing in compounders can be an effective late-cycle buffer. The earnings for the compounder-rich core sectors of our global portfolios today (consumer staples, software & IT services within information technology, and health care) which combined are over 80% of our global portfolios, held up far better than their more cyclical peers, as shown in the chart below. 

NTM Forward Earnings Per Share Change During Financial Crisis Drawdown
(Oct 2007 to Feb 2009)

Source: FactSet. Data as of February 28, 2019. Chart shown for illustrative purposes only.

On forward price-to-free-cash-flow, our favored valuation metric, our global portfolios trade on only a 10%-14% premium to the far lower-quality MSCI World Index, despite the far higher return on capital, gross margins and margin stability.6 We would argue that this is actually an overstatement of any real premium, given the market’s chronic general failure to deliver the expected forward earnings, the specific threats to market earnings at the moment, and the habit of tucking any unpleasant news “below the line.”

The aim is to compound wealth over the long term by owning high-quality companies that compound earnings steadily at reasonable valuations. In other words, to keep the lights on, rather than shooting them out. While compounders are a sound investment approach across the cycle… in our experience they have particular value when the cycle is coming to an end. 

Adapted from the Investment Insight “In Search of a Late-Cycle Buffer." For more information, ask your Morgan Stanley representative or visit Morgan Stanley Investment Management. Plus, more Ideas from Morgan Stanley's thought leaders.

Risk Considerations

There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market value of securities owned by the portfolio will decline. Accordingly, you can lose money investing in this strategy. Please be aware that this strategy may be subject to certain additional risks. Changes in the worldwide economy, consumer spending, competition, demographics and consumer preferences, government regulation and economic conditions may adversely affect global franchise companies and may negatively impact the strategy to a greater extent than if the strategy’s assets were invested in a wider variety of companies. In general, equity securities’ values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility. Option writing strategy. Writing call options involves the risk that the Portfolio may be required to sell the underlying security or instrument (or settle in cash an amount of equal value) at a disadvantageous price or below the market price of such underlying security or instrument, at the time the option is exercised. As the writer of a call option, the Portfolio forgoes, during the option’s life, the opportunity to profit from increases in the market value of the underlying security or instrument covering the option above the sum of the premium and the exercise price, but retains the risk of loss should the price of the underlying security or instrument decline. Additionally, the Portfolio’s call option writing strategy may not fully protect it against declines in the value of the market. There are special risks associated with uncovered option writing which expose the Portfolio to potentially significant loss.

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