Cycles – Companies and Sectors
The market often talks about the “cycle”. The business cycle, the economic cycle, big cycle, small cycle, credit cycle, etc. Beneath this, however, individual sectors of the market pace differently and therefore find themselves at different stages of the cycle at a given point in time. As we approach 4th quarter earnings, we find ourselves looking for data points on where, seven quarters into the pandemic, companies, and sectors are in the cycle.
One could liken it to participants of a division-less marathon. All participants are running the race but given different qualities and characteristics of the runners and the environment, the runners are spread out over the course. In the case of this cycle, we find that acting as a separator, the pandemic has caused more dispersion in sector/business model positioning within this cycle. Some sectors are seeing anemic recoveries or remain largely shut down, while others are seeing unprecedented demand that may be sustainable. For example, grocery stores vs. restaurants. Grocery stores are showing characteristics indicating they are much further along in the business cycle than restaurants.
Companies are given an opportunity during the earnings season to shed light on where we are in the cycle as they highlight the expected direction of cash flows, capital allocation, and alterations to their capital structure. These are metrics that we find crucial in understanding a company’s credit risk profile. Companies earlier in the cycle may have lower margins and free cash flow but capital allocation frameworks that are more focused on liquidity preservation and debt reduction. Companies later in the cycle may benefit from higher margins and stronger free cash flow but may also have capital allocation frameworks that prioritize aggressive organic or inorganic expansion and/or shareholder friendly returns.
Earnings updates and accompanying management commentary can not only give investors clues on where a company currently sits in the cycle, but also on the potential duration of the cycle. The pandemic has had a diverse impact on supply and demand across businesses and industries, and reactions from management teams have varied significantly. Understanding which changes may be more temporary or permanent can help investors determine how the current cycle may differ from historical observations. Furthermore, the introduction of 2022 guidance during the coming earnings season may be particularly helpful in this area.
In our experience, focusing on companies and management teams that are actively prioritizing credit risk profile improvement tends to lead to the best investment outcomes for investors. These are typically early and mid-cycle actions. That said, not all companies in a particular sector may be following the same playbook, making security selection and active management critical to success. Because the outlook for companies that are earlier in the cycle typically favors continued improvement and a more positive future, valuations can reflect this improvement and investors may underestimate the challenges currently facing the credit. Conversely, a late-cycle outlook for slowing or declining trends (a more conservative outlook) may result in pessimistic valuations that place a low probability on extended cycle durations.
While overall credit spreads may not be at historically attractive levels, we believe that the current investment environment is highly dynamic, with rapidly changing conditions across economies, industries, and companies. Dispersion in valuations of corporate bonds and where companies and sectors sit in the cycle only adds to this dynamism. This will create greater opportunities for active investors with a focus on security selection and risk-adjusted returns.
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