Asset allocation decisions can be challenging for investors during the later stage of the business cycle. Focusing on quality is likely the best way to manage the transition from late expansion to a potential recession, as we discussed in a recent blog. Picking up on this theme in the equity markets, we are in the midst of a dramatic shift in the ability of some companies to grow their profitability and drive cash flow. In the search for quality, we think focusing on corporate cash balances (too often overlooked by equity investors) is especially important for investors in today’s late-cycle market.
As Figure 1 shows, companies in developed markets – and in Japan and the U.S., most notably – have substantially increased their cash on balance sheet and improved their financial positions in recent years. Notably, this growth has occurred even as companies in general have been returning cash to shareholders at levels not seen since before the global financial crisis. In the U.S., buybacks alone have exceeded $2.8 trillion in the last five years and are on track in 2018 to beat all records, according to Standard & Poor’s, thanks in part to U.S. tax reform, which facilitates repatriation of corporate cash.
To put that in perspective, this return of cash to shareholders solely through buybacks has exceeded the expansion of the Federal Reserve’s balance sheet since the financial crisis. And yet, corporate cash levels overall have still not declined ‒ if anything, they have risen.
We see the ability to generate cash as an important component of any company’s quality. Investors should aim not only to identify companies that can grow earnings but also to assess the quality of those earnings, differentiating between true cash generation and accounting accruals, which are likely lower quality and unlikely to be as persistent over time.
Cash and valuation
How should an investor take into account such large cash balances? To the extent that cash levels tend to be concentrated among certain sectors and companies, one could argue that it’s prudent to adjust common valuation metrics. After all, creditors usually pay close attention to net debt as opposed to total outright debt.
As investors, should we consider a “net P/E ratio” (price/earnings) along with the usual P/E ratio? Netting out the cash and other current, liquid assets on corporate balance sheets, the adjusted net P/E ratios paint a somewhat different picture of the same four blue-chip indexes than the loftier levels of the usual P/E, as Figure 2 shows. And we could do a similar illustration with ROE (return on equity) – what is the “undiluted ROE” of an index when a large proportion of the price is made of cash, which essentially returns very little these days?
Ultimately, the net P/E ratio is likely to overstate the situation, as some cash is clearly necessary for the orderly and regular functioning of a business; the truth for purposes of valuation likely lies somewhere between the net and the standard P/E metrics. Still, that paints a valuation picture that looks much less exuberant than what standard P/E ratios at index levels have led us to think.
Incorporating the quality of cash into investment decisions
Companies with higher cash buffers will generally have more degrees of freedom, especially in an economic downturn, not only to buy back shares but also to maintain dividend levels.
By screening companies to take cash levels and their quality into account, one is able to build a basket of equities that not only exhibit higher quality but also come at a discount to the broader market. And the results of our screening are striking: Cash has disrupted traditional factors. Indeed, a large part of the market traditionally called “growth” has migrated into quality, while segments traditionally seen as “value” are more expensive than they look.
In our view, following the cash is a good way to find quality in the late-cycle market and prepare for the likelihood of more volatile days ahead.
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