With ongoing concerns about valuations, peaking growth, waning stimulus, higher taxes, rising rates, and inflation, it’s reasonable to question a new, broad allocation to the US market at this juncture. These concerns notwithstanding, State Street Global Advisors’ Fundamental Growth and Core Equity (FGC) team believes that the US equity market still offers a unique opportunity set of high-quality, long-term “compounder” companies that can be a core component of any strategic asset allocation. These are globally competitive franchises, operating in a supportive political environment, that benefit from technological innovation, dynamic management teams, and disciplined capital structures.
The changing business mix and steadily improving financial returns of US companies over the last several decades suggest that valuation multiples should be higher than historical levels. While there are always short-term fundamental risks, the long-term prospects for the highest-quality companies in the US market demand a sizable allocation regardless of your tactical asset allocation call.
As active fundamental managers with a long and successful track record, we have a biased view on how exposure to the US market can be best achieved. The widening performance differential between the best and worst US companies helps to justify this bias, revealing an investment landscape that is ideal for adding alpha through stock selection. As managers of concentrated, high-conviction portfolios, we help investors navigate the extremes in the market by avoiding overpriced growth stocks while also steering clear of lower-quality value traps. Our philosophy is based on “quality at a reasonable price,” which helps us construct concentrated, yet balanced, portfolios that provide better-than-average growth combined with the stability of lower-than-average volatility. Decisions are informed by our proprietary, forward-looking, framework for assessing quality.
Why the US Market?
The US equity market provides a rich opportunity set of global companies that have strong competitive positionings with underappreciated operating leverage and financial returns. The primary driver has been a multi-decade shift toward service industries with capital-light business models and higher associated margins. In addition to that, modern US manufacturing sectors have seen improving returns as they have benefited from global outsourcing, robotics, and automation. Today, the US equity market provides access to some of the most innovative companies in the world in the semiconductor, software, medical technology, internet services, ecommerce, and industrial automation sectors. Most of these players operate on a global scale1, driving improvements in operating leverage, returns, and free cash flow generation – and resulting in increased capital for companies to reinvest in further innovation that enhances their competitive advantage. Lower capital-intensity also means that excess cash can be returned to shareholders through dividends and share buybacks, which have soared in recent years.
In fact, a recent study by Empirical Research confirms that both gross and net margins for S&P 500 companies have been hitting multi-decade highs. This is confirmed by another study at Credit Suisse HOLT showing that the returns across the largest 1000 US companies have steadily improved for the last 40 years. However, not all companies have benefited equally. The bulk of the improvement has been driven by the firms in the top quintile, where CFROI2 has almost doubled to over 25%. By contrast, the bottom three quintiles have shown fairly stagnant CFROI over the same time period. The Credit Suisse HOLT study also shows strong persistence of competitive advantage, with a higher percentage of top-quintile companies remaining at the top over time. In sum, a fairly concentrated list of companies has driven the bulk of incremental economic profit over time.
When viewed with a discounted cash flow framework, the combination of higher returns and more durable growth implies a higher expected valuation for the US market as a whole and even more so for the highest-returning cohorts. The fact that the composition of the US market has changed so dramatically in the last few decades implies that using historical multiples as a reference point may be less relevant. It also suggests that comparing the US market to other international markets demands an analysis of relative growth and financial returns before making assumptions about appropriate valuation levels or expectations for multiple convergence. Just as one would not expect the valuations of secular growth technology firms and traditional financial firms to look alike, one should not expect the US market’s valuation to mimic other markets that contain a vastly different mix of constituent companies.
Why Active Fundamental?
While the US market looks attractive in the long term, the divergence within the market on both a fundamental and valuation basis suggests that a more nuanced approach is needed when it comes to exposure. We believe that an experienced active manager with a team of research analysts with domain expertise can focus that exposure on the companies with the best fundamental prospects. We want to own the persistent winners of the next decade while also being considerate of price and embedded expectations. Our investment philosophy emphasizes a combination of quality and sustainable growth at a reasonable valuation. The goal is to assemble a portfolio of high-quality names that can sustainably outperform the market with better-than-average earnings growth and lower-than-average volatility.
Our focus on quality is supported by a proprietary framework that we call Confident Quotient, or CQ for short3. Unlike traditional measures of quality that emphasize a simple combination of historical returns, earnings volatility, and debt, we define quality on a forward-looking basis and focus on qualitative measures like competitive positioning, our confidence in the management team, adherence to ESG principals,4 the appropriateness of the capital allocation strategy, the transparency of the business model, and the fundamental momentum of the business drivers. We leverage our long-tenured research team to quantify these “soft” metrics using our detailed CQ framework. With detailed financial models, our analysts produce a series of proprietary intermediate-term earnings estimates and a long-term growth algorithm. These growth estimates, combined with our CQ-defined quality metrics, inform our level of conviction in the long-term durability of firm growth – and the associated price we are willing to pay for it. Our CQ-defined quality universe filters out lower-quality names while our valuation discipline helps us avoid overpaying for growth at the other end of the spectrum.
Exposure to the US stock market provides access to a unique set of stocks with compounding growth and returns that are unmatched anywhere else in the world. It’s also understandable that investors don’t want to overpay for this exposure given the myriad risks that could add intermediate-term volatility in the market. By focusing on the highest-quality companies in the US market with the best competitive positions and proven management teams, you can get access to a select group of firms that can grow and adapt to a changing fundamental landscape. These companies can better manage their cost structure given global scale and can pass on inflation with better pricing power. With higher returns and cash flow, they can continue to invest to sustain durable growth by innovating to adapt to a changing world and consumer demands. With our proprietary research framework and our valuation discipline, the goal is to harness this unique market and continue our heritage of driving high-conviction excess equity returns.
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