Asset Allocation: Following the Cash to Find Quality in Equities
Asset allocation decisions can be challenging for investors during the later stage of the business cycle. Focusing on quality is likely the best way to manage the transition from late expansion to a potential recession, as we discussed in a recent blog. Picking up on this theme in the equity markets, we are in the midst of a dramatic shift in the ability of some companies to grow their profitability and drive cash flow. In the search for quality, we think focusing on corporate cash balances (too often overlooked by equity investors) is especially important for investors in today’s late-cycle market.
As Figure 1 shows, companies in developed markets – and in Japan and the U.S., most notably – have substantially increased their cash on balance sheet and improved their financial positions in recent years. Notably, this growth has occurred even as companies in general have been returning cash to shareholders at levels not seen since before the global financial crisis. In the U.S., buybacks alone have exceeded $2.8 trillion in the last five years and are on track in 2018 to beat all records, according to Standard & Poor’s, thanks in part to U.S. tax reform, which facilitates repatriation of corporate cash.
To put that in perspective, this return of cash to shareholders solely through buybacks has exceeded the expansion of the Federal Reserve’s balance sheet since the financial crisis. And yet, corporate cash levels overall have still not declined ‒ if anything, they have risen.
We see the ability to generate cash as an important component of any company’s quality. Investors should aim not only to identify companies that can grow earnings but also to assess the quality of those earnings, differentiating between true cash generation and accounting accruals, which are likely lower quality and unlikely to be as persistent over time.