Amid the wreckage of weaker businesses as the dust settles, they often get a head start on growth that can propel them through the next cycle. A key attribute that helps quality companies not only survive a downturn but continue to expand in the aftermath is their strong cash positions: or, more specifically, the fact they tend to be both cash-flow resilient and to have cash on hand. They say cash is king. After a crunch, possessing these twin cash advantages can be a kingmaker, helping quality businesses increase their market dominance. History suggests they have helped some quality companies outperform as a recovery gets underway.
Whatever the economic backdrop, revenues usually keep flowing for quality companies — or, if extreme circumstances do interrupt them, the hiatus would be expected to be brief before structural growth resumes. This is partly because they offer products and services that people need, which may sometimes be sold via subscription or as recurring purchases. They also tend to operate in growing industries where they have competitive advantages. Consequently, they aren’t as vulnerable when the economy slows.
Because they often have dominant market positions, quality companies may have pricing power, which gives them additional protection in a downturn.
Quality companies tend to have low operating expenses, especially low fixed costs. They are also capital-light, meaning they don’t need to spend a lot on maintaining, say, factories or sophisticated machinery just to stay in business.
Strong balance sheets are another feature of quality companies. As well as having relatively little debt, they typically have significant levels of cash and ready access to liquidity/funding on good terms, due to their strong credit ratings.
Together, these attributes give quality companies more flexibility in allocating capital – that’s an advantage not only in challenging times, but also when the storm passes.
During a crunch, quality companies can make productive use of share buybacks or temporary dividend cuts to ensure they remain resilient and to prepare for a changed economic environment. That is to say, they can suspend buybacks if required as they have not been reliant on borrowing to buy back shares in order to drive earnings-per-share growth.
When conditions improve, they can spend on growing their businesses or on acquisitions — at what may be a very advantageous time to do so, as some weaker rivals may have been eliminated or may be available for purchase at a low price. With a clearer field, the potential for robust growth is higher, which is why quality companies can be quick out of the blocks in a recovery. They are also likely to restore dividends sooner, if they reduced them at all — something income-seeking investors will particularly appreciate.
Simply put, after a shake-out, the strong tend to get stronger. The performance of Ninety One’s Global Franchise Fund — which seeks to identify quality companies through in-depth research — suggests as much, with generally above-benchmark returns in the year immediately after a market downturn.
Or course, those seeking to follow a quality investment style need to maintain valuation discipline, buying shares in quality companies at reasonable prices. With an active, research-intensive approach, that can be done at any time. But it is at times like the present, after largely indiscriminate sell-offs when share-price moves detach from fundamentals, that the opportunity to build a quality portfolio at low valuations is often the greatest.
And whether what follows the current turmoil is a prolonged slowdown or a swift bounce back, a quality portfolio’s combination of resilience in hard times and strong growth potential in recoveries could stand investors in good stead. DM/BM
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