Equity investors are facing a moment of truth. Is the stock market going to crest? Verifying the quality of portfolio companies today can make the difference between success and failure if conditions get tougher tomorrow.
US stocks have had a great run this year. The S&P 500 Index advanced by 16.9% through October 31, driven by solid corporate earnings and a supportive macroeconomic environment. Yet valuations are elevated at 18x forward earnings, risks abound and many investors fear a downturn is imminent.
Situations like these present a classic dilemma. Should you bail out of stocks—and forgo potential gains—or stay invested and risk getting hit in a downturn? But we don’t think this is really the right question to ask, since it’s almost impossible to time inflection points in the market.
Gaining Confidence for a Correction
Instead, ask the following question: If there’s a recession next year—or if the market takes a leg down—would you want to buy more of the companies that you already hold in your portfolio? To answer “yes” to that question, we think the following business characteristics of portfolio holdings should be closely examined:
- Stable Profitability— Focusing on profitability is a good way to test the durability of a business. High and stable profitability is usually a sign that a company has a differentiated and durable business—with a greater likelihood of persistent success, even in tougher times.
- Healthy Balance Sheets— Good businesses generate excess cash, which can be deployed by the company to create value. And a healthy balance sheet, with ample cash and without too much debt, provides a company with the freedom to invest in its future without being subject to the vagaries of capital markets. This becomes essential if interest rates rise and lift the financial hurdles for future borrowing and investment.
- Prudent Management—Companies with staying power tend to have sound leadership whose incentives are aligned with long-term economic value-creation. Experienced management is especially important when conditions deteriorate, as it is needed to steer companies through trickier business, financial and market environments.
Weathering the Storm
Companies with these virtues are typically capable of weathering down markets, in our view. Investors who can identify these traits, while applying an outlook of three to five years, can gain conviction to stick with a stock for the long term. Then, if a downturn strikes, they won’t have to scramble to figure out which holdings can withstand the pressure.
The uncertainty in today’s markets is real. By preselecting companies with the right attributes for good and bad times, an investor can be in position to buy more of existing holdings if prices come down and to prime a portfolio to capture even stronger return potential when a recovery develops.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.