Catalyst Funds
Rational Funds
Strategy Shares
Key Points
- A balanced portfolio holding companies that play offense & defense is key.
- In the new economic regime, certain style factors make the most sense.
- Certain “defense-oriented” brands are performing quite well today.
Balance in a portfolio can help smooth the bumps to offer a smoother ride.
I wanted to do a two-part series, one focused on the benefits of holding defensive business models that tend to perform well in more difficult economic periods, and one focused on playing offense through secular growth brands. 2022 was an odd year, the highest quality secular growth companies generally delivered solid fundamental business performance, yet their stocks generally got absolutely annihilated. Generally, it was the contraction of the multiple, or what investors were willing to pay for high quality, that the market clearly questioned. Ironically, many of last year’s best performers turned in average operating performance but money flowed to these stocks because they were “defensive business models”. The growth of passive investing and ETF’s has driven this basket of stocks mentality whether there is any logic or not. In the end, what makes an asset price go up is simply having more buyers than sellers.
At the highest level, I think investors have three main goals from the investing they do:
- Achieve attractive returns.
- Have as smooth a ride along the way as possible.
- Reach their target goal on time and intact.
How they accomplish these three goals is where the magic happens. In many cases, it’s BALANCE that helps them smooth the ride. To get some balance, defensive business models and the stocks of these companies are where investors can turn.
Important style factors for the new investment regime.
Style factors describe the characteristics of a business. Defense or offense. High quality or lower quality, highly levered or low leverage. Large versus small. Domestic sales versus international sales. Our team tracks a few dozen style factors so we can see where the returns are coming from in the market. Think of this like a pond for fishing. When the fish are only gathering in one part of the lake, the fishermen should gather there too. Our portfolios generally hold a portion of the companies with a high weight toward style factors that are working as well as having some exposure to companies that are out of favor but likely to see some resurgence in time. That way we always have some balance to the portfolio and there’s always a new emerging winner to consider. Overall, we tend to always be overweight the “quality” style factor partly because it tends to outperform long-term and partly because top brands tend to be high quality companies.
Year-to-date, the quality factor has gotten back to performing well after having a difficult 2022. Within the quality factor, these are some of the sub-factors that are working again: high free cash flow, high free cash flow growth, pricing power, strong balance sheets, revenue growth, better margins than industry peers, dividend growth and margin expansion. I have written many times; the big opportunity is to add to outperforming style factors when they go through shorter periods of underperformance. It may feel bad when you add but when you know how the movie ends, you’re never afraid.
Defense
Alabama coach Bear Bryant used to say, “defense wins championships.” The truth is, having a solid defense AND offense tends to win championships but in markets, defense tends to win in tough, uncertain economic environments because companies that have more defensive business models tend not to suffer big erosions in revenues and earnings. Their stocks tend to underperform in up markets and outperform in down or sideways markets but sometimes there are special companies that win more of the time. Having some exposure to both types of companies seems to make a ton of sense today. With that in mind, I wanted to discuss a few gems that seem to be all-weather brands while still having strong defense-oriented characteristics:
Hershey: HSY
Consumers all over the world love their snacks and chocolates. Hershey has been a monster in the industry and a stellar investment over many decades. The company is one of those special blends of stable, predictable grower and a key defensive for more turbulent economic periods. When you are happy, you snack. When you are sad, you snack more! Hershey management has been making very strong acquisition decisions in the snacking category and they are not done. Consumers love their products and have voted with their wallets. The brand has strong pricing power, understands how to integrate an acquisition and drive higher volume growth. From a style factor perspective, HSY scores incredibly well in key defensive areas: dividend growth, higher margins than peers, attractive dividend, strong FCF growth, size, low volatility (beta), high return on invested capital when compared to the weighted cost of capital (WACC), and very stable, predictable earnings trends. The perfect stock for this environment in our eyes.
Fun fact: HSY stock has handily outperformed the Consumer Staples sector, the top performing broad equity style, growth, and the Nasdaq 100 over the last 1, 3, 5, 15, and 20 years. Something as simple as snacks and chocolates can add a lot of value to a portfolio.
Costco: COST
First, I’ll admit something: I do not like the shopping experience at Costco. And yes, I’ve been a member for many years and yes, we visit Costco every week. That’s how powerful this model is. With the best management team in retail, Costco has been serving consumers globally for many decades. Imagine a business model where consumers pay the brand for the right to have access to the stores and its merchandise. Member renewal rates are about 90% and we all get great values when shopping at Costco. Yes, this great brand was a big Covid beneficiary but once you jump onto the hamster wheel, it’s hard to jump off. Their private label brand, Kirkland is a monster and would be the dominant category killer in most sub-categories if it were an outside brand. It’s estimated to have an annual revenue run rate of about $75 billion. Costco runs on slim margins and high volume so when you have significant private label success, you can expand margins without affecting consumer price points. There’s so much more store growth possible outside North America as well.
From a quality and defensive business model perspective, Costco scores quite well. High sales, strong economic moat, high free cash flow, top quartile dividend growth, still cheap on a price to sales basis, low debt, strong balance sheet, incredibly predictable earnings, very low default probability, and a significant amount of cash on the balance sheet.
Like Hershey: COST stock has handily outperformed the Consumer Staples sector as well as the top performing broad equity style, growth, and the Nasdaq 100 over the last 1, 3, 5, 10, 15, and 20 years.
My question to every reader: what percent of your portfolio holds stable, predictable brands that can play offense and defense while delighting you on a regular basis? I urge you to look around your house and identify which brands you will turn to in good times and bad. If the masses also feel that way, there’s a good chance they have been stellar investments too.
Disclosure:
This information was produced by Accuvest and the opinions expressed are those of the author as of the date of writing and are subject to change. Any research is based on the author’s proprietary research and analysis of global markets and investing. The information and/or analysis presented have been compiled or arrived at from sources believed to be reliable, however the author does not make any representation as their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated therein. There are no material changes to the conditions, objectives or investment strategies of the model portfolios for the period portrayed. Any sectors or allocations referenced may or may not be represented in portfolios managed by the author, and do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that any investments in sectors and markets identified or described were or will be profitable. Investing entails risks, including possible loss of principal. The use of tools cannot guarantee performance. The charts depicted within this presentation are for illustrative purposes only and are not indicative of future performance. Past performance is no guarantee of future results.
The Chipotle hypothetical cost averaging example highlights the potential power of holding core positions in industry leading brands and being committed to adding to these positions when the market acts irrationally. Cost averaging leading companies can add significant value to your long-term portfolio even if you do not catch the absolute bottom in the stock. Details on this hypothetical are below.
