Which Quality Stocks Can Survive a Downturn?

Which Quality Stocks Can Survive a Downturn?

9 Mar, 2023 | Stock Insight

While the S&P/ASX 200 is only around 3.5% shy of its all-time high back in August 2021, the last 18 months have been a bumpy ride for most investors. The effects of tighter monetary policy (including a 10th consecutive interest rate rise by the RBA), waning of the pandemic-induced boom in retail trading, and a weaker macroeconomic environment have taken their toll.
Recession Global Market Crisis Stock Red Price Drop Arrow Down Chart Fall

The full impact hasn’t necessarily shown up in the overall Australian indices, mostly because of the high proportion of materials and energy (24% and 6% of the ASX 200, respectively) that have benefited from the inflationary environment and war in Ukraine. The U.S.-based S&P 500, however, still sits nearly 16% below its all-time high despite a strong rebound in early 2023.

High-flying technology stocks and ‘pandemic winners’ have been particularly hard-hit, best seen by the dramatic fall of nearly 75% in Cathie Wood’s Ark Innovation ETF (NYSE:ARKK).  Locally, the S&P/ASX All Technology index remains nearly a third lower (~32%) than its all-time high in November 2021, and many individual technology names have experienced significantly greater drawdowns. Retailers, too, have come under pressure as interest rate rises have begun to pressure household budgets and the effects of booming lockdown conditions have abated and certain retailers have struggled with inventory management.

So for those interested in buying individual stocks, how can you avoid these huge share price declines?

One argument presented in the book The Intelligent Quality Investor: How To Invest in the World’s Best Companies is to look for companies with “linearity.” The author looks at the best-performing stocks over the last 40 years, and in somewhat of an anti-climax, the more the long-term stock chart trends up and to the right, the better. Author Long Equity notes that these companies with highly linear stock charts tend to be consistently profitable, reinvest their profits, and are not as severely impacted by economic downturns.

So how can we find these investments before it’s too late (and the chart goes too far up and to the right)? While there’s no comprehensive checklist, below are a few starting points.

1. Recurring Revenue with Inflation Protection

One of the challenges with businesses in certain industries is the need to keep the customer coming back. In construction, engineering services and many types of retail, for example, once the transaction is complete, the company no longer generates any revenue from the customer. Compare this to industries such as banking (where a home loan is paid off consistently over 25-30 years), utilities (mobile phone or internet bill paid monthly), or infrastructure companies. APA Group (ASX: APA) is one such example, generating revenue consistently from the transfer of gas through its pipelines along the east coast of Australia.

While demand does fluctuate due to economic activity and the weather, there is a consistent ‘flow’ each day, week, month and year. On top of this stable demand, APA’s contracts are largely indexed to inflation indices (such as the Consumer Price Index, or CPI), ensuring that its revenue keeps up with any rising expenses (and protecting the value of an investor’s money over time).

2. Strong Cash Generation and Negative Working Capital

The financial community focuses heavily on earnings according to the accrual accounting method, with press releases typically emphasising metrics such as “Operating Profit,” “Net Profit After Tax” and “Earnings Per Share.” The accrual method involves matching expenses against income, which is sometimes different from when the money is spent. It includes the likes of Depreciation and Amortisation (which averages a large cash capital expense over its useful life, such as for a new office building) and cost of goods sold, which includes the price of inventory.

In some instances though, accrual earnings can be a lot different from cash earnings (often called “free cash flow”). A retail company that is growing quickly, for example, will need to continuously buy more and more inventory to fill its growing store base and satisfy new customer orders. While this is great for future profits, it does mean that actual cash earnings will be lower than reported profits in the short term (cost of goods sold in the income statement will be lower than the inventory purchased using cash in the period. There will be an even bigger difference when inflation is high).

On the other hand, some companies get paid in advance by their customers: think of your monthly internet bill, a streaming service subscription, or an insurance bill. Australia’s leading insurance broker Steadfast (ASX: SDF) is one such example, generating a fee for providing small and medium-sized businesses with various types of insurance products. Importantly, the faster these companies with a ‘negative working capital cycle’ grow, the more cash they generate – their growth rate will not be constrained by the amount of cash they have available at any given time.

3. Solid Balance Sheet

Auditor auditing stock photo

This is probably the most often-quoted criteria, but just like eating enough vegetables and exercising regularly can help keep you healthy, it can’t be overstated (a point we’re happy for once to disagree on with investing legend Charlie Munger). While it does depend on the business, a general rule of thumb for most industrial businesses is for net debt (that is, total debt minus cash) to be less than three times EBITDA (earnings before interest, tax, depreciation and amortisation).

This is usually the maximum that banks and fixed income investors typically like to lend, and any more often causes a company to lose its coveted ‘investment grade’ credit rating from the ratings agencies (Moody’s, Standard & Poor’s, Fitch). Cyclical and highly competitive businesses, those with less recurring revenue, and industries that change more rapidly (e.g., technology and pharmaceuticals) would typically have less debt, while businesses with more stable operations such as utilities and infrastructure (e.g., toll roads, airports) can often tolerate higher amounts. Maintaining low levels of debt is not only important to ride out times of economic distress (when earnings and cash flow may decline), but to provide opportunities for increased investment, timely acquisitions or greater capital return to shareholders. Software provider Technology One (ASX: TNE) is a standout here, boasting nearly $176 million in cash and no debt at its most recent full-year results in September 2022, allowing the company to pay an ordinary dividend 8% higher than the prior year, alongside a special dividend.

4. Long Investment Horizon

One of the biggest negatives of being a public company is the constant scrutiny on performance, and the pressure from shareholders to keep the share price high. This can encourage management to emphasise a company’s short-term performance, cutting costs too aggressively or foregoing good investment opportunities to maximise current profits. A key differentiator for companies with extremely consistent long-term performance is their ability to extend their horizon. Often, this will mean investing more during a downturn as competitors retreat. Washington H. Soul Pattinson and Co. (ASX: SOL) is one of the more obvious ASX examples, having outperformed the ASX All Ordinaries by an average of 3.4% per year over the past 20 years (for a total return of +945% vs +461%). Having just clocked up their 120th AGM, long-term planning is obviously a priority!

5. Like-Minded Shareholder Base

It’s often quoted that companies ‘get the shareholders they deserve.’ Those that maintain a strong balance sheet, have quality financial reporting and a long-term investment horizon will inevitably attract shareholders who value those characteristics and are more inclined to stay invested during economic downturns, operational challenges, or periods of increased investment. Technology One is again the prime example here. Despite a high valuation multiple (currently an eye-watering 54x its last twelve months earnings), the quality of the company’s recurring revenue (software-as-a-service business model), fortress balance sheet (net cash position of $176 million, no debt), and long-term investment mindset (ability to reinvest in the U.K. despite several years of startup losses) have allowed the share price to not just hold up during the recent market turmoil, but it actually increase more than 43% over the past year.

A quality shareholder base can reduce the short-term pressure on management teams and allow them to pursue those investments most valuable to a company over the long-term. This is a key reason why Warren Buffett paid specific homage to Berkshire Hathaway’s shareholder base in his 2022 shareholder letter, and why Markel (NYSE: MKL) CEO Tom Gayner began courting Berkshire Hathaway shareholders at an early stage in Omaha.

Recipe for Long-Term Success

The last 18 months has been a challenging period for many investors, and may have proved a steep learning curve – particularly for the huge new cohort of investors that joined since the onset of the pandemic. While there are many ways to make money in the markets, the concept of linearity and quality investing might provide investors with a logical process for how to survive a downturn and grow wealth in a tax-efficient way over the long-term. Focusing on attributes such as recurring revenue, strong cash generation, a solid balance sheet, long investment horizon and a like-minded shareholder base has shown to generate some of the market’s biggest and most consistent long-term winners. Profitable growth, while passé the last few years, turns out to be timeless…like aviators.

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