As noted in our market update summarizing the first half of 2022, the equity bear market combined with the historic decline in fixed income provided no obvious shelter from “the storm” for investors. Of course, almost every person with even passing knowledge of the market acknowledges its ups and downs can resemble a roller coaster over the years. But this notion is much easier said when markets are placid, market screens are green, and charts paint the affirming “up and to the right” trend. Conversely, we believe it’s critical to acknowledge the very real psychological impact of enduring stormy markets when charts are “down and to the right” and implore all serious investors to remember the value of time in the market instead of trying to time the market. To help guide our clients and friends, we walked through a survival guide of sorts with what we hoped were helpful concepts to consider in last month’s blog Weathering the Market Volatility Storm.
The storm, unfortunately, persisted through June of 2022, and realizing this, we believe it helpful to dive into another critical aspect of our wealth management counsel: the thought process and methodology behind our long-held philosophy driving our Johnson Equity Income strategy. Equities are just one piece of the allocation strategy which includes a diverse portfolio of differing asset classes. Our Equity Income approach focuses on the large cap segment of the stock portfolio, which is complemented by exposure to small, medium-sized, and international companies. We believe some insight into this specific approach can be very helpful as a crystal-clear understanding of this philosophy can help serve as another psychological ballast against pulling the trigger on panic selling, permanent capital loss, and ultimately serious damage to a broader wealth plan.
Johnson Equity Income Philosophy
In short, this strategy seeks to provide investors with an equity allocation that over time, seeks to outperform the broader S&P 500 index on a risk-adjusted basis, using a dynamically managed portfolio of high-quality US equities purchased at reasonable valuations. We accomplish this through our in-house fundamental research methodology (detailed below) which intends to yield a less volatile, more sustainable building block for our clients’ investment strategies. Broadly speaking, this equity sleeve is designed to provide our clients confidence in the prospect of benefitting from the potential wealth generation associated with the compounding power of our country’s best run companies.
Why Quality Matters
The term “quality” can mean many different things to many different people. Given the subjective nature of this term, we define “quality” using some key empirical attributes reported by every publicly traded company. To start, we believe investing in quality companies provides much less risk of enduring a “disastrous loss” which is defined as a 70% decline in stock price from peak levels from which they never recovered. Since 1990, 31% (381) of the S&P 500 companies have endured this magnitude of loss and 315 of these companies were removed from the index. By owning “quality” companies we aim to avoid these types of catastrophes. In fact, since 2005, the S&P 500 had 207 of 856 companies (24%) experience this disastrous loss while our Johnson Equity portfolio had only 6 of 220 companies experience this type of loss. Clearly just avoiding the “potholes” can get a driver to their destination more effectively than reckless speeding.
So how do we evaluate “quality”? Essentially, we focus on three main attributes for our target companies: strong cash flow, a stable balance sheet, and an effective management team with a strong track record.
- Cash Flow: We’ve all heard “cash is king” in many circumstances and this is no different when evaluating companies’ success in their competitive markets. Cash flow is critical for two primary reasons. First, cash flow isn’t subject to the vagaries associated with nuanced accounting rules, which can be massaged to skew or obscure more telling financial results. Second, cash flow generation is a healthy read through to a company’s competitive advantages in its respective market. Taking it a step further, cash flow trends identify if cash generation is improving or deteriorating over time as an indicator of future performance. In the most basic terms, we strongly believe if a company can achieve a cash flow returns that exceed their cost of capital, with a stable and increasing trend in many economic environments, they clearly have a competitive and defensible “moat” around their business.
- Balance sheet: A strong and flexible balance sheet indicates a company’s ability to fund their operations and pay their shareholders without having to access capital markets for additional cash (through equity or debt issuance). Companies with strong balance sheets tend to be conservative in taking on debt which allows operations and even dividend payments can confidently continue when the economic cycle inevitably turns. We typically employ this criterion to eliminate potential investments rather than a stock selection tool as we seek to avoid the potential boom-and-bust volatility so common with companies with weak capital structures.
- Management team: Another subjective criteria for our “quality” screen is an effective management team. Again, “effective” can mean many different things, but we believe astute financial analysis can provide insight into how well a management team is running the operation in addition to cash flow. In the end, management teams are strategic allocators of the capital their investors have entrusted to them. Managers have a few main outlets to prudently invest capital and provide a return to shareholders who hold them accountable. Effective managers can balance the advantages and disadvantages of these tools, such as dividend payments, mergers & acquisitions, share repurchases, debt reduction, and investments in new initiatives. Short-sighted management teams can certainly provide a high-dividend yield to their investors, but they may risk starving other parts of business through underinvestment or miss an opportunity to retire high-cost debt. Accordingly, evaluating and prioritizing a management team’s long-term track record can be a helpful indicator of future success.
Valuation can be defined as the price one is willing to pay for a future stream of earnings. The higher the price relative to a company’s current (or future) earnings, the more optimistic the investor is that the company will deliver on its business plan to return cash to the shareholder. Despite all the historic advantages of identifying a quality company, a quality investment can only be executed if the price is attractive. Valuation serves as our effective “wrapper” around the quality attributes when deciding whether to include a company in our portfolio. We always view valuation through our quality lens as very often a “cheap” (low valuation) company can be cheap for a reason, such as a potentially deteriorating market or business model. Accordingly, we tend to be more opportunistic in seeking out investment opportunities when the market may be broadly pessimistic (as indicated by price) than the true fundamentals of a quality company may indicate. We believe using a seemingly attractive valuation as the sole driver in criteria for purchase, without the context of knowing the quality and fundamentals of a business, can be dangerous and result in a “disastrous loss” which is worth avoiding at all costs.
Constructing, guiding, and maintaining families’ wealth plans over many generations is the heart of what we do. The investment portfolio is the engine that drives these plans so a prudent asset allocation with quality investment management is critical to the success of these plans. We believe our Equity Income approach can be a core building block to this investment strategy. The first half of 2022 was an unfortunate reminder the “sunny days” of steady market returns will be interrupted by occasional storms. We hope this insight into our process will provide confidence and peace of mind when markets are turbulent.