As dividend income investors, we are focused on sustainability of profit margins over a full cycle. I believe that we are currently in the later stages of the profit cycle, with corporate profit margins at about 1% below their late-2014 peak levels. What does that mean for us as high-conviction, bottom-up investors?
First and foremost, we are not macro investors. However, our fundamental research process does offer insights, particularly with respect to the profit cycle. We want to understand how companies are over- or under-earning over time.
A key focus for us is knowing how much of the operating improvement has come from structural versus cyclical factors. We want to identify the parts of a company’s operating profit recovery that stem from structural changes, such as supply-chain improvements or fixed-cost management, compared with more cyclical factors such as decreased funding costs due to low interest rates.
These structural and cyclical factors have come together to create a robust profit cycle, particularly in the U.S. Understanding this is an important element of our research process.
Cyclical vs. structural drivers
A change that I believe is more permanent in nature is better supply-chain-management functionality. We are seeing increased focus on improved cost-structure initiatives, particularly in the U.S., with initiatives like zero-based budgeting1 being embraced by many companies within the more stable growth sectors of the economy.
Conversely, cyclically low interest rates are unlikely to be sustainable longer term. Interest-rate changes are important to both the cost and capital structure of a company, which are reflected in a company’s interest-coverage ratios2. We do think some of these changes are adequately reflected by sell-side analysts, but not all. Our process normalizes these key inputs of a firm’s cost structure to understand their potential profitability over a full cycle.
Today, some of our models are indicating that companies are over-earning relative to their full market-cycle potential. This is an area, in my opinion, where we differ from other investors in today’s market.
Investing in today’s environment
There are many policy unknowns on the table right now around the globe – central-bank policy, leadership changes and potential changes to the U.S. tax code. These are all significant. For example, if the U.S. tax-code changes are realized, it would be a change we haven’t seen in 30 years. One such change being discussed is eliminating the ability for corporations to deduct interest expenses. Companies optimize their balance sheet to leverage debt, so this potential change would have a real impact on how companies view their capital structure.
We’re not political strategists , and we don’t make calls on the policy initiatives in Washington. However, we do monitor it closely because expectations around these various policy unknowns are discounted in advance and often embedded in stock prices.
As mentioned above, I believe that we are currently in the later stages of the profit cycle – sales growth has slowed, productivity remains weak and the labour market is tightening. We focus on companies that can use self-help initiatives, including productivity initiatives or changes to their business mix, to offset these headwinds.
We seek to find companies with yields that are both attractive and sustainable – companies with strong balance sheets, attractive cash-flow generation and those that are returning capital to shareholders. Not all yields are created equally, and our focus on defensible yields helps us avoid yield traps.
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Keep an eye out for more commentary from Meggan, covering her strategy around dividend reductions, avoiding yield traps, risks in the current market and more.
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