An aging profit cycle and higher valuations suggest now may be a good time to prepare for downside risk
The ninth anniversary of the current bull market recently occurred in March — which is the second-longest period without a 20% drop in the closing price of the S&P 500 Index.1 While some market-watchers debate exactly how to measure the beginning and end of a bull market, the Invesco Global Dividend Income Fund team is focused on the profit cycle and valuation. We believe the profit cycle has moved into its latter stage and that valuations are currently extended. With this in mind, we remain focused on our fundamentally driven, bottom-up process.
Where markets are today
No one knows exactly when today’s bull market will end or when the appetite for growth and momentum stocks will abate. But we may see some key indicators that suggest growth opportunities may be harder to find. We are not macro investors, but our bottom-up research process offers insight about how the drivers of corporate earnings can change over a cycle. This profit cycle has seen the largest profit margin expansion in 50 years despite a weaker than normal economic expansion versus previous cycles.2 A key question for us is how much of the expansion is structural, due to factors like better supply chain management and reduction of fixed costs, and how much is cyclical, due to factors such as corporations benefiting from lower funding costs due to historically low interest rates.
We believe the profit cycle is in its later stages as profit margins have peaked,2 the credit cycle has troughed, sales growth remains below historical recovery period levels and wage/cost pressures are rising with a tightening labor market. Further, productivity growth has averaged 0.6% since 2010 compared to 2.1% on average for each business cycle since 1948.3 In the absence of greater topline and/or productivity gains, operating leverage will naturally decline in the latter stages of a cycle, and management teams will look for other ways to generate returns. We have seen this transpire with both share buybacks and M&A activity being consistent with prior peaks of 1999 and 2007.4 Though we generally applaud the return of capital to shareholders via buybacks, we don’t believe this is always the best use of capital, particularly when companies are repurchasing shares at expensive valuations.
How we’re positioned for tomorrow
Our goal is to help investors earn monthly income, preserve assets and build capital while helping to mitigate the inflation and interest-rate risks of traditional bond portfolios.
Over the past year, we have been very focused on our downside risk analysis, stress-testing our company models to help determine how companies may perform in a less favorable environment for profits.
Our biggest overweight versus the benchmark is in the consumer staples sector. (The fund had a 20.34% weighting in the sector versus 9.06% for the MSCI World Index as of Dec. 31, 2017.5) We have high conviction in the resilience of cash flows and earnings generated by our consumer staples holdings, particularly given efforts in recent years to improve margins by reducing costs and complexity, implementing supply chain efficiencies and optimizing brand portfolios.
Another sector in which we’re overweight is utilities. (The fund had a 10.95% weighting in the sector versus 2.97% for the MSCI World Index as of Dec. 31, 2017.5) We have identified several investment opportunities in utilities based on our triangulated valuation approach as sentiment, particularly around rising interest rates, created dislocation in stock prices.
Our biggest underweight is in information technology (IT). (The fund had a 1.39% weighting in the sector versus 16.76% for the MSCI World Index as of Dec. 31, 2017.5) Most of the best performing names in 2017 were momentum-oriented, which is not a part of our investment process. Within the value universe, some companies are subject to secular risks given rapid technological change that could negatively impair their business model. Today we see IT companies with high valuations and/or business models threatened by these secular changes.
We are also underweight in financials. (The fund had a 9.60% weighting in the sector versus 18.09% for the MSCI World Index as of Dec. 31, 2017.5) We believe financials are modestly attractive today on a P/TB (price to tangible book value) basis. However, we have a more conservative view of banks’ full cycle ROA (return on assets) versus the Street.
The goal of our strategy is to provide potentially better downside preservation and moderate upside participation by investing in companies with above-market, defensible dividend yields. More recently, we have placed particular emphasis on managing downside risk through sensitivity analysis of our modeled assumptions, given our belief that the profit cycle appears to be waning, valuations are extended, and the narrowness of market conditions warrants focus.
Learn more about Invesco Global Dividend Income Fund.