Seek Quality When the Outlook is Cloudy: Political Populism and Inflation Are Our Future
Ronald Reagan was shot 69 days after inauguration. The former Screen Actors Guild liberal leaning union leader turned conservative used the massive sentiment of the event as a catalyst to launch the Reagan Revolution. He boosted military spending, cut taxes, reduced federal spending, and reduced regulations (might sound familiar to some Trump fans except for cutting spending). Two score years later, inequality in America has never been greater. Actually, that’s not true, it was just as bad in 1929. As popular as Reagan was (in his early years), he had a massive economic tailwinds from baby boomers hitting their stride. From the birth of the microchip and the technology (productivity) revolution. From massive declining interest rates and inflation. This boom followed a great stagnation and an era of wars (hot and cold) and a decade of stagflation and brutal decade for capital markets. It was relatively easy compared to what this economy has yet to come to terms with.
- Grossly underfunded promises (social benefits) pension and health care
- Massive need for infrastructure investment (just to maintain/fix broken stuff)
- Major concerns about the environment (carbon, clean water, pollution, plastics etc…)
- Tragic demographic mix for future growth (dependency ratio)
- Massive decline in productivity (output per unit of labor)
Political populism is not new. In fact, it might be one of the oldest professions. Playing to the marginalized person promising them you will improve their lives. In my humble opinion, America will not be great again until we fix inequality. And if America is not great, it is hard for the rest of the world to be great. And now China wants to be great again too (which we discussed a few weeks ago and heated up again this week). The focus on boosting the stock market has not worked for the people. It has definitely worked for some people, but not the people. In fact, it makes the problem worse. According to a study by Americans for Tax Fairness and the Institute for Policy Studies’ Program for Inequality, the 600 billionaires between March 18, when most states were in lockdown, and May 19 saw wealth rise $434 billion. I’m not advocating for a universal basic income, but I think it is coming. I also believe that a massive wealth redistribution is coming too—I’m am not happy about it. But for the economy to be great again, incomes need to rise for the bottom half—it is that simple. Not for the top quartile, but for most. They call it the gutting of the middle class. That is an upgrade—it is tragic. When 50 per cent of the population do not have $400 for an emergency, something is very wrong. We see political populism trend everywhere and it will lead to more extremism. These trends are measured in years and decades not days and weeks. It is a modern-day civil war—make no mistake about it. It is a secular shift.
As a portfolio manager and as end educator on BNN, one of my jobs is to identify where the play is going and how to best capitalize on it. Corporate profit margins are going down. Growth potential will get worse. It is only a question of when, not if. How much do we pay for that in terms of the market multiple? The answer is less.
There are great companies to own to be sure. But there are many zombie companies that need to be retired. We are past the best before date for many in the retail space. Department stores for example are the buggy whip of today. There are many others too. Easy money policies are keeping many companies in business that just do not work anymore. There is a huge difference between the high yield debt of Netflix or Tesla versus Peabody energy and JC Penny. The later should go bankrupt in what is known as constructive obsolescence and make room for new companies that work for tomorrow. They are sucking up productive capital. Do you know how many of the top blue chip companies exist today that were the top companies 100 years ago? You can basically count them on one hand. How many of the FAANGM companies to you think will be around in a similar capacity 100 years from now?
So what are the characteristics of a good company to own if we are heading for a few decades of stagnation and stagflation? Technology is clearly part of the future. Companies that will help us live healthier and better lives to be sure. Companies that are more environmentally friendly should have an edge too. Arch Coal changed their name to Arch Energy this week as they look to survive. Companies that have good free cash flows. Companies that have good corporate stewards leading. Companies that do not leverage up to buy back their own shares to boost compensation of senior executives. Companies that do not work just because money is cheap.
In investing, there is a concept called factors. These are unique characteristics of companies like value, growth, low volatility, dividend, size, quality and about one hundred others. I love the quality factor.
The quality factor refers to the tendency of high-quality stocks with typically more stable earnings, stronger balance sheets and higher margins to outperform low-quality stocks, over a long time horizon. The outperformance of high-quality stocks over low-quality stocks is well-documented in financial literature although the actual measure of “quality” is disputed. Metrics such as a company’s earnings, dividend payments and debt levels have all been shown to have as much explanatory power in relation to a stock’s performance as the value factor.
Quality-based strategies try to capture the premium associated with high-quality stocks versus low-quality stocks. However, of all the risk factors, this is perhaps the hardest to define as investors are divided on the best way to measure quality. Depending on the investment manager, quality can mean gross profitability, return on invested capital, growth, stability of earnings, high payout rates, or low volatility and fundamental risk. Regardless of the metric, strategies that attempt to target quality typically outperform the market, as they are better equipped to weather adverse economic conditions.
Since launching ZGQ (BMO MSCI All Country High Quality Index ETF) in November 2014, it has outperformed the MSCI All Country World Index by massive 13.89% to 5.22% annually. Now that is the kind of inequality we are bullish about!