In brief

  • Many companies are leaning on their non-core businesses to maintain margins, but investors are becoming increasingly wary.
  • Avoiding companies with unsustainably high margins is key.
  • While the real economy is better positioned than in the prior two cycles, that does not mean the financial markets won’t see stress.

Despite global equity markets providing double-digit returns in the first half of the year, investors are discriminating to a degree that has not been seen in years. At the margin, capital has shifted away from companies that profit greatly from non-core operations.

While companies are doing everything they can to maximize returns, some are disproportionately dependent on things outside of normal business operations such as supply chain financing, share buybacks, increasing leverage and the like. The market is also concerned about companies struggling to pass on higher input costs to their customers, which have resulted from rising labor outlays, tariffs and supply chain disruptions.

This year, after nearly a decade of monolithic market movement during which well-managed companies performed about the same as those less well managed, there has been  a fundamental shift. Investors have become much choosier late in the business cycle, and dispersion has resulted in significantly more alpha opportunities for active managers.
Year to date, there have been three areas of underperformance:

  1. Companies with high levels of leverage
  2. Companies with falling gross margins, often resulting from a lack of pricing power
  3. Lower-quality cyclicals.

It has been our experience that avoiding companies without durable business models can create value for discriminating portfolios with a quality bias, as was the case in the lead-up to the global financial crisis.

The current cycle is less of a bubble

There are two key differences between our present market cycle and the two cycles that preceded it.
In the prior two cycles there was:

  1. Overinvestment in certain sectors of the real economy
  2. Overexposure to those overbuilt sectors.

For example, in the late 1990s, investment in fiber optics and other technologies drastically exceeded the demand for those technologies. Investors bought into a narrative that cash flows would eventually emerge to justify a massive infrastructure build-out. Those cash flows never materialized, and valuations ultimately mean-reverted.

A similar story played out in residential real estate in the mid-2000s. Investors loaded up on bonds and structured products levered to residential real estate assuming 1) home prices would never fall and 2) homeowners would continue to pay their mortgages. Both those assumptions proved faulty.

Is it different this time?

Somewhat. Today, there are fewer excesses in the real economy. And that’s one reason the present business cycle has been long in duration but below average in strength. There’s less investor euphoria today than in 1999 and 2007, and unlike in the past two cycles, there are no obvious cycle-ending bubbles ready to burst.

However, I don’t think investors appreciate the unsustainability of the high margins many companies enjoy today. Few notice the games that chief financial officers are playing with balance sheets and income statements to maintain those margins. But there are only so many non-core levers that CFOs can pull to avoid the inevitable. And shrinking margins, in my view, are inevitable for those without a viable value proposition.

Important Information

MFS or MFS Investment Management refers to MFS Investment Management Canada Limited and MFS Institutional Advisors, Inc.  This article was first published in the United States by MFS. in August 2019 and is distributed in Canada by Sun Life Global Investments (Canada) Inc., with permission. This document is provided for information purposes only and is not intended to provide specific financial, tax, insurance, investment, legal or accounting advice and should not be relied upon in that regard and does not constitute a specific offer to buy and/or sell securities.

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