Era of Deleveraging and High Quality
Investment Strategies

“Quality is never an accident; it is always the result of high intention, sincere effort, intelligent direction and skillful execution; it represents the wise choice of many alternatives.”
— William A. Foster

For years, financial institutions were more than willing to extend credit haphazardly to feed the insatiable spending and speculative appetites of consumers, investors and businesses. Last year, however, the window on this era of excessive leverage slammed shut, exemplified by the demise of several long-established firms, massive write-downs by financial institutions, rating downgrades, increased margin and capital calls, and a crushing of consumer confidence initiating a global credit freeze.

Since 1981, the U.S. GDP has increased by about $11 trillion, while private sector debt has ballooned to an astounding $22 trillion. Over the last decade, economic growth (as measured by GDP) has averaged 2.7% per year. Yet, during that time, the debt burden has increased at a pace of almost twice that amount.(1) This growth in the debt burden was clearly unsustainable, and we are now experiencing the painful process of unwinding the excess leverage.

As we struggle through the effects of global deleveraging, certain businesses may be more adversely affected than others by tighter credit terms and increased limitations on sources of financing. Many businesses finance working capital costs such as inventory and payroll, as well as most of their longer-term capital budgeting projects. In a new era where it is no longer feasible to load up the balance sheet with debt, high quality companies that have appropriately positioned themselves to endure and thrive should perform well relative to the overall market. In today’s environment, the lower leverage carried by high quality companies makes them particularly attractive investments. Without a significant dependence on external sources of financing, high quality companies can grow their business through internally-generated sources, leading to positive and more consistent earnings, which should provide the investor with price appreciation and/or a higher dividend yield.

The following characteristics typically define a high-quality company:

  • Consistent earnings and dividends
  • High, recurring cash flows
  • High returns on capital
  • Dominant competitive position
  • Strong, shareholder-friendly management
  • Low financial leverage

One common measure of these characteristics is Standard & Poor’s Earnings and Dividend Rankings(2), which rates companies from A+ (highest) to C- (lowest) based on the growth and consistency of earnings and dividends. When one applies these rankings to the various sectors of a broad index, such as the Russell 3000 Index, observable trends are present based on the quantity of higher or lower-rated companies and the sectors in which they operate. For example, the financial services sector has a much larger relative exposure to lower-rated companies than the consumer staples sector, which has a relatively large percentage of highly-rated companies.(3) As a result of its lending operations, the financial services sector unavoidably maintains highly leveraged balance sheets while the consumer staples sector enjoys the consistent earnings that are a by-product of stable demand for their products.

Trends can also be observed when one applies these quality rankings over the market capitalization spectrum. As you may expect, the larger, more highly capitalized and established companies tend to be more highly-rated. Smaller companies have increased levels of volatility which makes maintaining consistent earnings and dividends more difficult, thus resulting in lower ratings for small-cap firms and a lower percentage of highly-rated small-cap companies relative to their large-cap counterparts.(4)

The secular decline in highly rated companies is also noteworthy. A-rated companies accounted for over 30 percent of all ratings in 1985, but by 2004, they only accounted for 13 percent. Over the same period, C-rated companies increased from 12 percent to 30 percent. This dramatic decline in quality across equities can largely be attributed to the increased presence of financial leverage and the corresponding increased exposure to volatility and earnings variation.

In summary, well capitalized companies in appropriate sectors of the economy are likely to outperform their smaller capitalized, more highly leveraged counterparts during turbulent economic times, i.e., those with high levels of uncertainty and volatility. As expectations increase for a persistent and volatile downturn, investors should consider pursuing a high-quality strategy to seek downside protection. Furthermore, with a diminishing number of companies possessing high-quality characteristics due to the proliferation of financial leverage, it is especially important to understand your strategic allocation to these types of investments and to frequently evaluate all of your investments and managers.

1 Charles Schwab: A Transformational Era of Deleveraging
2 S&P’s Quality Rankings. Rankings range from A+, A, A-, B+, B, B-, C+, C, C-
3 Rogerscasey, S&P, Barra
4 Rogerscasey, S&P, Barra