Why quality organizations are best positioned to navigate the current economic environment
- Given the U.S. Federal Reserve’s (Fed) current policy of monetary tightening, it is important to consider what types of companies are best positioned to successfully navigate a rising rate environment.
- During periods of monetary tightening, the stocks of companies with high Return on Invested Capital (ROIC) have historically delivered excess relative returns.
- Investing in high ROIC companies, particularly at dislocated valuations, presents a compelling risk/reward opportunity in today’s environment.
Policy Rate Backdrop
After an extended period of exceptionally easy monetary conditions, the Fed and many of its global counterparts have begun raising interest rates in an effort to reign in excessive inflation. Their goal is to increase the cost of credit thereby cooling demand, which is outstripping supply. The ability of central bankers to tame elevated prices without pushing the economy into a recession will be a challenge, particularly given heightened geopolitical tensions. For the stock market, with historically high equity valuations not seen since the Global Financial Crisis in 2008, this issue is of serious concern.
Exhibit 1: Inflation Reaches 40-Year High While Fed Funds Rate Remains Relatively Low
Source: FactSet, US Department of Labor, Federal Reserve. Data from December 1970 to May 2022.
Why ROIC Matters
Companies with high ROIC are well positioned to navigate this economic and market regime due to several key characteristics:
- These organizations often maintain strong competitive advantages with efficient cost structures, thereby enabling them to consistently generate economic value even as the cost of capital is rising.
- They typically participate in market sectors with favorable characteristics during periods of rising interest rates and benefit from significant barriers to entry.
- Organizations that have demonstrated a sustained level of high ROIC are frequently led by leadership teams who understand the core competencies of their respective organizations, have a disciplined approach to capital allocation, and take a longer-term view on shareholder value creation. In addition, an ROIC focus at the executive level is often reinforced through proper governance and incentive systems.
During periods of monetary tightening, rising interest rates effectively raise a company’s hurdle rate for both internal projects and external mergers and acquisitions. When lower ROIC peers are struggling to identify attractive investment opportunities given the higher cost of capital, best-in-class ROIC companies can still extract value through strategic capital deployment and re-investment. These allocation decisions can in turn lead to increased market share despite moderating economic growth.
The Return Advantage of High ROIC
The stocks of high ROIC companies have often delivered excess relative returns during historical periods of monetary tightening. The table below highlights how companies with high ROIC levels have performed in the last five Fed rate hike cycles. High ROIC names (as defined by the top quartile of securities within the Russell 3000® Index) have generated alpha relative to the Russell 3000 in four of these cycles. While acknowledging history may not repeat—and that each of these cycles wielded its own unique set of circumstances—the relationship between this quality characteristic and returns may prove informative.
Exhibit 2: Performance of High ROIC Companies During Periods of Monetary Tightening
Source: FactSet, Russell, Federal Reserve. Past performance does not guarantee future results.
ROIC Opportunity Set
The accommodative rate environment observed through 2021 caused investors to seek out riskier and more speculative investments to generate returns. As a result, less mature companies—those with inherent risks, such as unproven business models or minimal to no earnings—were able to attract capital and issue equity. This cash-burning subset of the market has increased in recent years—currently more than 800 Russell 3000 constituents do not produce positive returns, as shown in Exhibit 3. While a portion of these newly formed organizations will develop into truly disruptive and profitable companies, many will not. Rising interest rates can have compounding effects on these companies’ sentiment (declining risk tolerance), capital structures (increasing financing costs), and valuations (lowering the present value of future cash flows).
Exhibit 3: Distribution of Returns on Capital of Russell 3000 Constituents
Source: FactSet, Russell. Data as of 4/30/22. Past performance does not guarantee future results.
SBH ROIC Focus
The team at Segall Bryant & Hamill (SBH) implements a bottom-up, fundamental research approach to evaluate and understand the return profile of potential investments. This involves thoroughly analyzing the financial health of current/prospective companies and regularly interacting with management teams to assess their capacity for sustaining or improving ROIC.
By focusing on high ROIC, we believe we are aligning our clients’ capital with quality organizations that may be best equipped to navigate volatile economic conditions – conditions that can be catalyzed by means of a monetary policy shift. Those companies with strong balance sheets, resilient free cash flows, thoughtful capital allocation practices, experienced executive ranks, and leading ROIC profiles are situated to generate value over the duration of market cycles while simultaneously providing downside protection. Buying securities that demonstrate this set of characteristics, particularly at dislocated valuations, presents a compelling risk/reward opportunity in an uncertain market environment such as the one in which we find ourselves today.
For more information, please reach out to us at firstname.lastname@example.org or visit sbhic.com.
Last updated June 2022. All opinions expressed in this material are solely the opinions of Segall Bryant & Hamill. You should not treat any opinion expressed as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of the manager’s opinions. The opinions expressed are based upon information the manager considers reliable, but completeness or accuracy is not warranted, and it should not be relied upon as such. Market conditions are subject to change at any time, and no forecast can be guaranteed. Any and all information perceived from this material does not constitute financial, legal, tax or other professional advice and is not intended as a substitute for consultation with a qualified professional. The manager’s statements and opinions are subject to change without notice, and Segall Bryant & Hamill is not under any obligation to update or correct any information provided in this material.