Two opportunities in a world awash in debt

The implications of a world awash in debt and a record rise in interest rates are just being felt in the economy and markets. In my previous article I made some observations on building resilience into investor portfolios as we navigate uncertain times ahead.

Today I offer up some examples that can hopefully form the basis for investors to do their own analysis on holdings in their portfolio and selecting new investments.

Evaluating individual shares

Computershare (ASX: CPU) is not an exciting business. Then again investing isn’t about excitement. Computershare is leading provider of share registry services and several adjacent records management services.

Is the company resilient in the face of competition?

The first thing we want to look for when trying to find a reliant company is how it may respond to an evolving competitive environment. Operating a business in an environment with inflation and uncertain economic growth can be difficult. Inflation and slower growth cause businesses and consumers to scrutinise their spending and can lead to shifts in demand.

A company with a sustainable competitive advantage or moat has advantages in any environment. Those advantages can come to the forefront during difficult times. Our analysts give Computershare a wide economic moat due to switching costs and cost advantages.

High switching costs mean there are barriers to customers moving from Computershare to their competitors. There are few benefits from a company moving their share registry from Computershare and significant operational, reputational, and regulatory risks from moving on from the industry leader. Computershare has a close to 100% customer retention rate.

Records management is a business where there are significant advantages in scale. And Computershare is the industry leader which gives them marginal cost advantages over competitors. Multi-year contracts and a high retention rate make it difficult for competitors to build the scale needed to become competitive.

What could go wrong for the company in the future?

As investors we care about the ability of business to continue to generate earnings into the future. The underlying value of the business is based on these future results. All businesses face risks that may impact their ability to continue to generate profits. But these risks vary based on the nature of each business. Our analysts capture the inherent risks to future cash flows for each company they cover in the Morningstar Uncertainty Rating.

Before investing in any company an investor should consider what could go wrong. Will a slowing economy impact the company significantly or are the products and services they sell resilient to economic conditions? What is the degree of competition in the industry the company operates in? Is there the potential for disruptive technology? Does the country control pricing conditions or are they a price taker? Does the company have the financial strength to weather the vicissitudes of a uncertain future?

Computershare receives a Medium Uncertainty Rating which is our second lowest level. Like any business there are risks but overall we think they are relatively subdued with Computershare. They consist largely of the chance of lower interest rates which reduce the amount Computershare earns on client funds they hold, increased price competition given their dominant share in the registry business and integration risk of acquisitions.

One area we don’t see material risks is due to the financial condition of the company. Computershare’s business model is capital light and there is recuring fee revenue which makes future cash flows more predictable. The debt to equity is reasonable at 1.34 and the cash flows are resilient to economic cyclicality. An example of this resilience is the fact that Computershare did not need to raise any equity capital during the 2020 COVID recession and share market decline.

Quality factors

One way to build resilience in a portfolio is through the simple act of diversification. Single company risk is reduced by the simple act of having more holdings. One of the easiest ways to diversify is by buying an ETF.

Given the overall debt levels in the economy this diversification is further enhanced by finding an ETF which specifically seeks out companies in strong financial condition. This is where a factor ETF can come into play. A factor investment approach seeks to build a portfolio based on desired attributes that have historically provided positive investment outcomes.

The VanEck MSCI International Quality ETF (ASX: QUAL) is one such example which receives a Silver Medallist Rating from our analysts. The ETF applies a screen to identify high-quality shares in 22 developed market countries based on three factors: low financial leverage, high return on equity and reliable earnings growth.

Return on equity is a figure that measures how effectively a company generates profits. A high return on equity can be an indication of a sustainable competitive advantage and is similar to the high return on capital that our analysts use.

Meanwhile reliable earnings growth is a screen that can eliminate cyclical companies whose earnings vary significantly according to the business cycle. This resilience in the face of economic conditions can provide protection for an investor.

Finally low degrees of leverage is a key component of resilience. It can provide downside protection in worsening economic conditions and allow a company not just to survive but allow continued investment in the business. This can come through internally generated cash flows and continued access to debt markets in more constrained environments.

We can see the impact of these quality screens on the overall portfolio. Over 90% of holdings receive a Wide or Narrow Moat Rating from our analysts compared to under 70% in the Morningstar Category of Equity Large Blend ETFs and Funds.

An uncertain future

Any investment should be aligned to the goals of each individual investor and suit their temperament and intellectual approach to investing. Successful investing is long-term investing, and that alignment means less of a chance you will churn your portfolio.

In the face of the shocking degree of debt built up since the GFC there is a case to be made that assessing the resilience of your portfolio may be a valuable exercise for many investors. The future is of course uncertain but buying quality companies is an investment style that has paid off for long-term investors in a variety of market conditions. Are there examples of quality investments in your portfolio? I would love to hear the approach you are taking at mark.lamonica1@morningstar.com