The US equity market has been strong over the past few years, outperforming emerging markets and developed markets in Europe and Asia. This year, however, investors have had to contend with bouts of increased market volatility, with rising trade tensions offsetting solid earnings data and increased merger and acquisition (M&A) activity. Spreads on investment grade corporate bonds have widened to reflect tapering demand, recent debt-funded consolidations and relatively large supply. A decision by the US Federal Reserve (Fed) to raise its benchmark rate for the second time this year indicated confidence in the strength of the US economy. But while the Fed has raised its short-term economic projections, this has not been matched with its long-term expectations for economic growth.
Diversification in uncertain times
Macro risks are to be expected this late in the cycle and the uncertain geopolitical backdrop – a full-blown trade war being the biggest (but in our view unlikely) threat – has complicated the situation. In this environment, many investors are concerned about where they should put their money to work, given the lack of obvious options to help them meet their objectives, whether that is retirement obligations, to build up a nest egg, or save for college education.
Given the level of uncertainty, it is paramount that we maintain a disciplined focus on stock/security selection – both in terms of those securities we favour and those names we think have higher inherent risks. We try to be diversified in terms of our exposure to different sectors or themes. A key attribute of our investment strategy is the ability to dynamically adjust our exposure to different asset classes – equities and bonds – based on where we see the best relative returns. The decision between equity and fixed income is effectively a competition for capital, where we actively discuss whether the equity team or the fixed income team has better opportunities to put money to work. In our view, this active dialogue gives our strategy a competitive edge.
A collaborative structure
Decision analytics business Verisk is a good example of the collaboration between our equity and fixed income teams. This was a smaller, underfollowed business that aggregates and analyses loss data collected from insurance companies. It then sells the data back to help improve predictive analytics that assist underwriters to model risk. Verisk launched its initial public offering in 2009 and then issued debt for the first time several years later. Given its lack of previous debt issuance, this was a name that had no prior coverage on the fixed income side. However, the close working relationship of our equity and fixed income teams meant that our equity analysts were able to quickly cover the salient points relevant to the company, and a decision was made to participate in the bond issuance.
The relationship went further. In 2015, Verisk announced the acquisition of Wood Mackenzie, a data analytics company in the energy, chemicals, and metals & mining sectors. Working as a team, our equity and bond analysts were able to secure a call with the CEO and CFO – roles that are often not incentivised to meet with bondholders. We were able to discuss the management team’s plans – in particular, their intention to deleverage the balance sheet after the acquisition. In this case, both equity and bondholder interests were aligned, as debt reduction benefits both stakeholders.
An eye on both sides of the story
We think that generating positive absolute returns year after year is an important goal, regardless of the macro environment, and our investment decisions – both in fixed income and equity – are made on that basis. In terms of equities, we look for companies with high and improving margins, delivering a decent return on invested capital (ROIC) and free cash flow (FCF) growth, in industries with growth potential. The fixed income side provides ballast for the overall portfolio, holding a combination of US Treasuries and better quality corporate bonds, with an eye to both income and growth potential. We believe that our investors, ultimately, want total return. That is what is going to pay their bills, whether they get it in the form of capital appreciation or in the form of income.
In our view, sustained economic growth and corporate tax cuts lead us to believe that equities offer more attractive risk-adjusted opportunities than fixed income at present. We are, like many others, concerned about the pace and impact of rising interest rates, rich valuations and debt-funded M&A in the current cycle. Nonetheless, companies are generating attractive free cash flows and reinvesting in their businesses, resulting in solid revenue growth and earnings. This, combined with some wage growth and continued strength in consumer spending, provide a modest tailwind for equities as an asset class. As ever, we remain focused on companies with good growth prospects, and those innovating with technology to improve the efficiency and quality of their products.