The Dow posted its largest decline of 2019 Wednesday as the bond market signaled a warning of a potential pending recession. With weak economic data coming out of China and Germany, the second and fourth largest economies, respectively, there are worries that we are in the midst of a broad global economic slowdown. As stated in the Wall Street Journal, the good news is that unlike the 1990’s with the Tech boom or the mid 2000’s with a housing boom, the US is not confronted with severe excesses to unwind. As such, any downturn might be mild.

When market volatility picks up, it is reasonable for investors to get antsy about their investments and lose confidence in the market. We believe volatility provides a perfect opportunity to calibrate our investment philosophy and not get sucked into media headlines or brash reactions. Although we identify where we are in economic and market cycles and position portfolios to benefit from these cycles, we do not try to time the market. We are long term investors, not traders. By identifying that we are in the beginning stages of a downward cycle, we are able to make changes in a portfolio to be more defensive and try to safeguard our investments. For example, recently we have taken several steps to shield the portfolios from risks that we currently identify by selling positions, raising cash, and taking a more cautious approach to investing new monies.

Our investment process comes from more of a bottom up approach. Meaning we try to analyze specific companies who can perform well in all market cycles. Instead of trying to predict what will happen in the next week, quarter, or year and basing our investment choices off of a prediction, we try to invest in good companies. When we pick companies, we strive to choose companies that we think of as “recession resistant”. This does not necessarily mean that its stock price will not be negatively impacted during a market sell-off. Our definition of recession resistant means that the companies’ long-term value will not be materially affected and the business will not be forced to change its financial situation or market position during a downturn in the cycle. Quite the contrary, we believe that many of our companies’ competitive positions would become stronger through a recession and are in a position to take market share from competitors.

We have a yield bias in our portfolios meaning we prefer to hold companies that pay a dividend and can grow that dividend overtime. In fact, a large percentage of our companies are known as “Dividend Aristocrats”. These are companies that have not only paid a dividend, but increased their dividend consistently for at least 25 years in a row. These companies exhibit business stability and also dependable management with shareholder friendly priorities. Further, these dividend payments may soften losses during turbulent times or recessions, particularly when the equity markets produce negative returns. When dividends are paid, they act as a cushion and are positive whether stock returns are positive or negative. Also, it’s interesting to note that the average age of the companies in our portfolio is over 80 years old. We believe that this shows they are able to adapt and overcome several market, economic, and business cycles and come out not only whole, but better on the other side.

History has shown us that the most vulnerable companies in a recession are those that are highly leveraged, those that rely on the capital market to finance themselves, and those whose business models only work when the economy is very good or there is some sort of short-term tailwind assisting them. We have gone to great lengths to ensure that none of our companies fall into this category. We favor companies that are highly profitable, produce strong cash flows, have exceptional management teams, and do not need to rely on the market for capital to operate. Most investors are very aware of the risks of using leverage or debt in their personal lives but do not think twice about the balance sheet leverage of companies in their portfolio. We have heavily scrutinized this aspect of our portfolios. Of course, not all debt is bad debt and when used properly, debt can be a useful tool for companies. But when that debt is not being used efficiently it poses risks to the company and the overall portfolio. Many of our companies actually hold net cash on their balance sheets meaning they could pay off all of their outstanding debt today with cash on hand if they wanted to.

Lastly, another core principle of our investment philosophy is to not overpay for our companies. A company may be qualitatively strong in our opinion but if the market has bid its price up too high, it will keep us on the sideline until we believe it becomes attractive. If you pay too high of a multiple for a business, that business will have to grow its earnings at sometimes an astonishing rate for you to receive an attractive return. If these high growth companies miss their earnings target even by a small margin, it can create large swings in the stock price and can stagnate invested capital for long periods of time.

Given the recent volatility, we feel it’s important for us to reinforce our strategy of buying proven enterprises that pay us a dividend, are not overleveraged, and have healthy balance sheets. Feel free to contact us if you would like to have a more in-depth review of your portfolio or would like to speak in more detail on how we feel our strategy is best positioned during volatile markets. 

 

 

Disclosure: Covington Investment Advisors, Inc. is a Federally Registered Investment Advisor.  The information contained herein is general in nature and is provided solely for educational and information purposes and does not constitute legal, financial or tax advice.  Opinions and forward-looking statements expressed are subject to change without notice.  Past performance is no guarantee of future results.  Covington Investment Advisors, Inc. uses reasonable efforts to obtain information from sources which it believes to be reliable and does not endorse, approve, certify or control the third-party content referenced.