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November 28, 2011 at 07:00 PM
The past decade has not been kind to most equity investors and their advisors. Two bear markets, two recessions and dramatic swings in volatility have prevented many from meeting the return assumptions built into their investment plans.
Looking forward, advisors and their clients are struggling to see how they can meet future liabilities with little expected return from fixed income allocations and diminished faith in equity markets. Economic growth will likely continue to be anemic over an extended period of time given the structural impediments facing economies in many parts of the developed world, and volatility is likely to remain high.
It seems that many market participants are counting on increased allocations to hedged strategies or alternative asset classes to serve as both an engine of high return and a brake on downside volatility—something very difficult to engineer. Advisors should consider a category that presents a realistic option for powering long-term return objectives with moderate risk by looking at high-quality, predictable global businesses with strong cash-flow growth—sustainable growth companies that can expand even in uncertain times. The good news is that the skepticism of equity markets and the recent dominance of short-term investment strategies have presented a big opportunity in this category. The stage is set for sizeable excess returns in a straightforward long allocation to a selective group of growth equities—an opportunity hiding in plain sight.
The great challenge for advisors these days is to get the proper configuration of the long equity portfolio to deliver good returns with moderate risk. Index strategies will likely continue to be disappointing as corporate profit growth is stalling and will likely be scarce in coming years given economic headwinds. It is imprudent to expect expansion given the uncertainties about growth and financial stability. It is the combination of strong cash-flow growth and high quality that advisors should seek out, focusing on those rare high-quality businesses that enjoy secular growth tailwinds as well as unique competitive advantages that protect profitability. These companies can predictably sustain above-average growth regardless of the environment, while maintaining high levels of cash-flow productivity. This ensures a portfolio with a low level of business risk, the risk that a company’s growth trajectory will be derailed either as a result of the environment or competitive challenges.
Price risk—the risk that you can buy a great sustainable growth company and still generate disappointing investment returns by overpaying for it—must also be managed carefully by adhering to a cash-flow-based valuation discipline. Unlike many who may choose to focus on operating earnings to make valuation judgments, we analyze the future streams of cash flow available to shareholders (CFATS) to determine the real value of a business. CFATS is a conservative estimation of the cash ultimately available to business owners, unvarnished by accounting after all claims, like acquisitions, unfunded liabilities and necessary capital expenditures. It is the bedrock of empirical value.
