Why Quality May Shine as Volatility Increases

Why Quality May Shine as Volatility Increases

Uncertainty abounds of late. The equity markets are seemingly caught in a daily tug-of-war between mixed macroeconomic data points and stronger microeconomic news from corporations reporting quarterly earnings in many different industries. Layer on top of that the standoff between the ECB and policy makers in both Europe's core and its periphery, as well as our own anxieties about the U.S.'s fiscal viability, and you have a volatile mix. To be sure, the equity markets have demonstrated impressive resiliency of late, especially in the face of this intense macro uncertainty. In fact, as of this writing, the Russell 2000 Index remains roughly within 5% of its all time closing high. So what is driving this disconnect between the macro and micro worlds, and how should one be positioned in this uncertain time?

In a recently published report, Francois Trahan of Wolfe Trahan & Company wrote, "In the old days, a double-digit growth rate in U.S. earnings would have been a bullish statement for GDP. Indeed, most economists have earnings as a component of their GDP framework. That said, the link between corporate earnings and job growth in the U.S. broke down about a decade ago, so there is little now to infer from strong earnings when it comes to GDP."

There is no shortage of issues weighing on the collective psyche of investors and corporations alike. Following the financial crisis of 2008, fear of another global economic disturbance is never far from the mind.  Corporate cash levels remain elevated—the Russell 2000 Index, excluding Financials, had about 17% of its market cap in cash at the end of the second quarter 2011 according to Bank of America.

Our view remains that there has been, and continues to be, a very narrow lens through which pundits are viewing the overall economy, focusing almost exclusively on housing and unemployment, and for the moment sovereign default. At the same time, however, our own work continues to show pockets of strength in the overall economy with increased activity in many different sectors and industries. It should be noted that there is a real industrial recovery in the United States, stemming from market share gains due to the weak dollar on top of emerging market demand for our products. The current economic conditions are quite dynamic and so much more fluid than the daily headlines portend. Value is being created—it is being built across the market-cap spectrum even as multiples compress, creating opportunities for value conscious active managers like us.

For some time we have suggested that higher-quality companies would lead in the market recovery regardless of market capitalization and especially as the economic recovery matures to expansion. As we have mentioned before, high-quality stocks look attractively undervalued, are defensive by nature, and tend to perform better in periods of heightened volatility. From our perspective, a continued increase in volatility might provide the catalyst for an even greater focus on quality. The shift in market leadership to high-quality stocks, which have been outperforming since January 2011, is a trend we believe can continue.

So while volatility will most likely increase over the next several months as the market enters what is historically a difficult few months, we remain steadfast in our approach and in our focus on quality. The fortunes of quality companies in all asset classes will resemble the growth in the economy—slow and steady, not very dramatic, but in retrospect highly satisfying.

Stay tuned…
FDG

P.S. We saw an interesting quote from a recent research report by Steven DeSanctis of Bank of America Merrill Lynch entitled "Tech is cash rich – Buybacks & Dividends boost performance" with which we wholeheartedly agree: "One of the reasons we like Tech is the fact that its balance sheet in aggregate is very clean. Companies in the sector have an awful lot of financial flexibility to try to enhance shareholder value and have become very attractive takeover candidates. As of June 30, 18.6% of Tech's market cap sits in cash and this is the highest level in all of small caps. The overall universe, excluding Financials, has about 17% of its market cap in cash."