by Michael Hunstad, Northern Trust
While the ongoing economic recovery is durable and we advocate an overweight to equity, the growing body of high-multiple companies of lower financial quality and higher leverage may prove a significant performance headwind and add materially to a portfolio's tail risk. How can investors avoid this danger? Let's take a look.
Although the current earnings season has generally exceeded expectations, outcomes have been far from uniform. Within the Russell 1000, 87% of companies we consider high quality, those with stronger profitability, cash flows, and balance sheets, beat their earnings expectations. In contrast, about half of companies we consider low quality missed earnings expectations. And when they did so, the reaction was punitive.
When low-quality companies missed, their prices dropped about 2 and 1/2%, with the highest-multiple, low-quality companies dropping about 3 and 1/2%. Clearly, there are very high earnings expectations built into lower-quality, higher-multiple names, leading to elevated levels of tail risk. As the equity market prices in more downside volatility, avoiding these expensive, financially challenged companies is a solid play.
With the secular fall in interest rates over the last 2 decades, there has been a notable shift in capital structures toward debt and away from equity. This has led to a substantial increase in interest rate and credit sensitivity for many companies. In 2001, just 10% of S&P 500 stocks had negative tangible equity, meaning their debt exceeded the value of all physical assets. As of August of this year, that number has grown to 40%.
Among small-cap stocks, currently more than 1/3 have interest coverage ratios less than 1. For this reason, equity benchmarks in general and highly levered stocks in particular are now more susceptible to rate and credit shocks, outcomes that may stem from inflation and COVID-related events. With the cost of portfolio insurance near all-time highs, the market is pricing in a heightened probability of a much higher volatility environment should markets sell off. While we're bullish on equities, stocks that are higher quality, have less leverage and lower multiples will carry less risk and have more upside potential.
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Michael Hunstad, Ph.D.
Head of Quantitative Strategies
Michael Hunstad is head of quantitative strategies at Northern Trust Asset Management with responsibility for all quantitative equity research, strategist, and quantitative equity portfolio management activities.
