When prices are rising fast, companies face a variety of pressures on both the cost and income sides of their businesses. We believe that high-quality companies, with strong and consistent cash flows, have more ways to protect their margins even as input costs increase. Pricing power—an important quality feature in any market—is an essential attribute; it allows companies to push prices up without worrying about taking a hit to demand.
Measures of profitability, such as return on assets or return on invested capital, are important quality indicators and strong predictors of future earnings power. Similarly, companies that demonstrate capital discipline will be prized in a rising rate environment. Companies that we call quality compounders have successful business models and sustainable earnings, backed by good capital stewardship and positive ESG behavior. Intangible assets such as brands, culture, R&D and patents are also valuable features, particularly in times of stress. These attributes support compounding earnings gains from consistent growth drivers through market cycles.
Finding Stability in More Predictable Earnings
Protecting portfolios from geopolitical tensions is tough. Risks such as the war in Ukraine or election outcomes, are inherently unpredictable and may have surprising effects on markets. Predicting geopolitical outcomes isn’t a prudent investing strategy, in our view. However, we can focus on stocks that have more more predictable earnings patterns than others, even in difficult times with limited visibility. Over time, our research suggests that companies like these tend to outperform the market, with better risk characteristics, lending stability to a portfolio.
Stable companies come in many forms—and are often not typical defensive stocks. Take the technology sector, which was never really considered a defensive part of the market. Yet today, some tech companies provide services that are so integral to the global data infrastructure that their earnings and performance patterns are as dependable as utilities—a more traditional defensive play. Technology enablers are an important piece of the puzzle, as they provide essential hardware, software and services to address current macroeconomic and geopolitical stresses. In contrast, hypergrowth technology stocks don’t have defensive characteristics, and many have indeed sold off sharply this year.
Valuation Focus Helps Reduce Risk
Stable stocks won’t get the job done if they are too expensive. That’s why it’s important to verify that stocks trade at relatively attractive valuations when constructing a defensive equity portfolio. Today, when rising interest rates can induce valuation risk, maintaining price discipline improves the chances of success for a lower-volatility equity portfolio.
Focusing on these attributes is the key to creating an equity portfolio that will fall less than the market in a downturn. More moderate declines make it easier to recover losses faster when the market rebounds. In times like these, when the outlook is so cloudy, it’s hard to imagine when the inflection point will come. Staying in a carefully curated portfolio of stable stocks of quality companies can help ensure that an investor will benefit from better times ahead.