The high-growth companies caught in this valuation trap are big and important. It is why the “magnificent seven” have drifted for the best part of a year. But these companies do not tell the whole stock market story. Alternatives in the equity market can live more easily in a less yield-friendly environment. The trick is to balance the equity portion of our portfolios towards them.
To do this, I am focused on five characteristics, all of which point in the same direction – away from distant, uncertain earnings streams and towards cash flows that are large, visible and distributable. What you might call jam today.
My first preference, then, is for lots of free cash flow today rather than the promise of earnings growth tomorrow. This is not the same as buying shares that look cheap. A company such as Microsoft offers growth and is not particularly cheap, but it throws off cash now as well as in the future. The dividing line isn’t between growth and value, but between profits generated today and profits whose value depends on what happens many years from now.
Fortunately, plenty of factor-focused exchange-traded funds (ETFs) explicitly screen on cash flow and other valuation measures. iShares has one, the World Value Factor ETF, which picks about 400 companies from the MSCI World index that look undervalued relative to a range of fundamental measures. It trades at about 17 times earnings, meaningfully cheaper than the rest of the market.
It offers global equity exposure without the expensive, high-growth shares most at risk in today’s high-yield environment.
Second, I expect dividends and buybacks to become more highly prized in the new world of competitive bond yields. When interest rates were close to zero, investors preferred to reinvest cash rather than distribute it. In the future, many of those potential investments will not stack up. What will matter increasingly is shareholder yield – dividends plus the effect of share buybacks.
The challenge is avoiding the high-dividend trap, where a stagnant, leveraged company pays unsustainable income. I prefer a lower but reliable dividend that can grow with time. Again, both actively managed funds and passive ETFs focus on delivering this growing income. Wisdom Tree has a Quality Dividend Growth ETF.
The third characteristic I am looking for in a higher-inflation environment is pricing power. We need companies that can reprice their revenues faster than their costs rise. This is hard to spot quantitatively. It is not an accounting ratio. And it may be where an active stock picker earns their keep over a passive fund.
Morgan Stanley and – full disclosure – my employer, Fidelity, have Global Brands funds that explicitly focus on intellectual property and pricing power. Another important trap to avoid is this. Pricing power is often associated with the quality-investing style, and that can too easily become “quality at any price”. The goal is pricing power with cash generation and a reasonable valuation.
In a high-yield environment, quality matters most in a company’s balance sheet. Persistently high yields expose companies that could easily refinance when money was cheap but struggle when capital costs rise again. Refinancing a 2pc bond at 6pc is as painful for a company as it is for a homeowner. And the pain comes with a lag.
Companies that borrowed cheaply for five or 10 years have been insulated, but every refinancing resets their cost of capital. The ideal is a company that receives interest rather than pays it.
Which leads to the final consideration – geography. The US is more heavily valued on jam-tomorrow profits. Much of its value rests on technology and anticipated growth. Exactly the characteristics I am leaning away from.
The UK is almost the opposite. With exposure to financials, energy, commodity-related businesses, and high-dividend payers, our home market is potentially in the value sweet spot, despite the obvious challenges facing the domestic economy.
Europe and Japan also contain many mature, cash-generative industrial, financial and shareholder-return-focused companies. Japan, in particular, offers several elements of this jam-today investment approach in one place. Reasonable valuations, cash-rich balance sheets, improving capital allocation and growing buybacks and dividends. Japanese companies are consciously moving excess balance-sheet cash back to shareholders.
Reshaping the equity share of a portfolio helps maintain long-term exposure to the best-performing asset class while reducing vulnerability to the possibility that a rising cost of capital could bring this mature bull market to an abrupt end.
In a world where capital once again has a meaningful cost, it recognises the prudence of receiving our investment return sooner rather than later. Some good things can still happen above 5pc. But you have to look harder to find them.
Tom Stevenson is an investment director at Fidelity International. These views are his own
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