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WHEN THE GOING GETS TOUGH, THE TOUGH GET GOING: QUALITY GROWTH VS. CYCLICAL GROWTH IN BOOM & BUST
ARCHIVÉ - 01/07/2014
Wolfgang Fickus
Product Specialist / Investor Relations Manager
INTRODUCTION
Many fund managers would probably argue that the ‘super cycle’ (2002-2007) was a great period compared to the subsequent years that followed the global financial crisis, often referred to as the ‘low growth environment’ (2008 to-date).
If we take a look at open ended funds invested in European large caps, for example, 45% of portfolio managers outperformed their benchmark during the super cycle1, but by a small margin (average 1.37% p.a.) and by taking comparatively high market risk (average beta of 1.05)2. The percentage of outperforming open-ended funds significantly shrank during the ‘low growth environment’3 to only 29%. Their outperformance was more significant (2.17% p.a.) and achieved with lower market risk (average beta of 0.97)4. This data suggests that it can be a rewarding strategy to outperform over a full boom and bust period by making the difference during the bust, especially when adjusting for risk.
Comgest’s Pan-European Equity strategy (a/k/a “Rep. Acct.”)5 has outperformed in this way over the 2003-2013 time period. Comgest’s large cap European portfolio participated in the upswing of the ‘super cycle’, but generated strong relative performance in the ‘low growth environment’.
This pattern of outperformance mirrors our quality growth approach and its capacity to deliver earnings growth, that is less sensitive to the economic cycle. The autonomous growth path of quality growth companies6, which is generally driven by microeconomic success factors and megatrends, should allow them to grow earnings even when economic growth is weak or negative. This makes them resilient to economic downturns, mostly coinciding with equity bear markets. Quality growth companies also tend to participate in the earnings upside embedded in economic upswings, but less so then companies geared to the economic cycle.
IN Comgest's VIEW,
THE ECONOMIC CYCLE is - at Best - difficult to forecast and - at worst - a random variable for portfolio management
The challenge is to adequately identify quality growth. As we will see later, this requires both bull and bear cycle experience. The challenge is particularly evident in a prolonged economic upswing. For example during the ‘super cycle’ of 2003-2007, many growth companies which initially appeared to be quality growth companies turned out to be cyclical growth companies, driven by what was an extraordinarily strong and long economic boom period. With a quality growth approach at Comgest, our analysis is not diverted by what we believe is – at best – difficult to forecast and – at worst – a random variable for portfolio management: the economic cycle.
This paper was originally written in 2014 and has not been updated since publication.
Footnotes
1 Performance measured from 1/1/2003 to 31/12/2007. Source: Morningstar.
2 Only 17% of the fund managers outperforming during the ‘super cycle’ also managed to outperform during the ‘low growth environment’.
3 Performance measured from 1/1/2008 to 31/12/2013. Source: Morningstar.
4 13% of open ended funds invested in European large caps outperformed both in the bull and the bear market.
5 Refers to Comgest’s Pan-European Equity Representative Account (“Rep. Acct.”), a pooled investment vehicle which has been managed in accordance with the strategy discussed since inception of the strategy.
6 Comgest defines “quality growth” as growth, which is protected by a sustainable competitive advantage (i.e. brand, technology, scale). This competitive advantage must allow quality growth companies to earn a RoI in excess of its cost of capital and to grow its EPS by more than 10% p.a. with strong visibility in the long-term, which corresponds to our 5-year forecasting period at least. Strong cyclicality of a business model usually impacts the visibility of long-term earnings growth despite a strong and sustainable competitive advantage, which might exist. We avoid strong cyclicality in our portfolios. Certain sectors are prone to competitive advantages, which are short-lived, such as frequently in the consumer electronics industry. We try to avoid franchises in these sectors, if we estimate that the competitive advantage is not sustainable in the long-term.