What's Important Now? As Always, Focusing on High-Quality Companies

What's Important Now? As Always, Focusing on High-Quality Companies

Uncertainty continues to reign. The confidence crisis that has already slowed the pace of global economic activity has only intensified over the past several weeks.  Odds of a recession in the United States seem to be growing, while a recession in Europe seems all but certain.  Even the September Federal Reserve Open Market Committee meeting did little to assuage recessionary fears.  In its statement, the FOMC downgraded its assessment of the economy yet again while noting that "there are significant downside risks to the economic outlook, including strains in global financial markets." 

Not surprisingly the global equity markets sold off dramatically following this dire assessment and yields on the U.S. 10-year Treasury note hit fresh 60-year lows.  Once again we are in a period of significant market volatility as the secular forces of deflation bump against recurring rounds of policy re-flation.  Fundamentals matter little of late as macro sentiment rules the day.  What, then, in this uncertain environment is important to us?

First, the indiscriminate selling over the past month is allowing us to re-enter some of what we see as our highest quality names at absolute valuations that look very attractive.  As we have mentioned before, high-quality stocks currently look undervalued, are defensive by nature, and tend to perform better in periods of heightened volatility.  Here, our conviction has not wavered. 

From our perspective, quality is critical to mitigating risk and achieving above-average long-term returns.  As long-term investors, we believe that companies with sound fundamentals should deliver superior returns over the long term, particularly when purchased at attractive prices.

Driving our investment process is a rigorous search for quality that begins with an examination of a company's historical returns, with particular focus on return on invested capital (ROIC).  For us, this metric reveals the first markings of a quality company, which can be found in its historical returns over full business cycles. 

Interestingly, a recent research report from Furey Research Partners highlighted the fact that, measuring by ROIC, as of the middle of September 2011 the highest quality small-cap companies within the Russell 2000 Index now trade at a discount to the highest quality large-cap companies, while the lowest ROIC stocks account for virtually all the small-cap premium to large (see chart below).

To be sure, we continue to believe that high-quality smaller companies are inexpensive and the source of great potential value.

Second, volatility continues to rise.  Dramatic swings in market performance have become almost a daily occurrence.  Steven DeSanctis of Bank of America Merrill Lynch pointed out in a recent report that the percentage of days the intraday high and low for the Russell 2000 Index was greater than 1% has gone from 10% in 1993 to over 77% through the end of August 2011.  The percentage of days when the spread was greater than 2% was over 29% through the end of August, while in 1993 the percentage was zero. 

Volatility is thus part of the investment landscape.  This is not necessarily bad news, as we have always believed that volatility, as well as corrections for that matter, create enormous opportunities. This time should be no different. Consider the following: from the interim small-cap peak on April 29, 2011 through the most recent market low on September 22, 2011, the Russell 2000 declined 25.2%. During this downturn, 808 companies (41% of the index) were down 30% or more; 464 companies, or 24% of the constituents, lost 40%; and 10%--207 companies—fell more than 50%. 

As we have always done during especially difficult periods, we are adding risk as the market is removing it by reducing valuations.  If we are doing our jobs well, the stocks we are adding to and initiating positions in today should drive strong performance in the years to come, especially given currently attractive valuations. 

So while uncertainty abounds, our approach remains consistent.  As we have said before, volatility will most likely increase or stay elevated over the next several months as macro uncertainty persists, while we remain steadfast in our approach and our focus on quality. To us, that has always been important!

Stay tuned!
FDG