Janet Johnston, Portfolio Manager, TrimTabs Asset Management
Ahead of her speaking slot on strategies to generate alpha at Inside Smart Beta and Active ETFs, Janet Johnston analysed if we are really in the time of a trade crisis or if we are really in a Goldilocks, market-friendly environment.
Are we in a trade war crisis or a market friendly goldilocks environment? The consensus seems to change from week to week - even day to day. How can active management, defined as 100% human discretion, add value in this environment? Most importantly, how do we create resilient core portfolios that can be held over the long term in this environment of sharp reactions to headline risk?
The elephant in the room is the trade war crisis. Up until the beginning of May, the US administration had been signaling that a trade deal was likely and moving forward. Investors are rightly concerned about the escalation and the potential impact on the US and global economy should this agreement not come to fruition.
Despite a slowdown in global growth last fall, a US government shutdown, and bad weather, the US economic numbers have been better this year than expected, with no sign of a recession or inflation, Q1 GDP was above 3%, and Q2 estimates are positive.
While strategists expected Q1 earnings growth to be negative year over year, earnings growth for the S&P 500 is now positive year over year, and revenue growth is now above 5%. Productivity is improving and margins are steady. Absent the trade war, we seem to be in a goldilocks economy – not too hot and not too cold.
So how do investors navigate this environment? At TrimTabs Asset Management we invest in quality companies with strong organic growth that we hope to hold over the long term. For us, the most important consideration is robust free cash flow growth. Our research indicates that free cash flow growth over the long term generates alpha over traditional cap weighted indices. Free Cash Flow provides some cushion to help companies fund future growth and mitigate any unexpected stress conditions.
At TrimTabs Asset Management, we use free cash flow growth as a reality check on reported corporate earnings. It’s common knowledge on “the Street” that companies manage earnings. Management has significant discretion in terms of how they report revenues and expenses, along with the valuing of assets. We think of free cash flow as harder to manipulate: fact, not management opinion.
In our multi-factor models we combine free cash flow with strong balance sheets and actual share reduction. Strong balance sheets provide more cushions for our companies to mitigate risk. We look at share reduction because as investors, we want a bigger piece of the investment pie. Ideally, companies are buying their stock with free cash flow and not debt.
We want to avoid companies that are leveraging up their balance sheets to engineer earnings per share growth.
In this era of quantitative innovation, automation, and the quest for low-cost solutions, simple factor models often overlook the complexities and multiple dimensions of an investment. As active managers, we can dig a little deeper and looks at risks and opportunities that our models can’t anticipate.
The US consumer has been solid over the last year, with record low unemployment, rising wages, and strong balance sheets. If you look at our current core US portfolio (TTAC – the TrimTabs All Cap Free Cash Flow ETF) versus last summer, you would see more consumer and defensive names, more services companies without supply chain risk, and more stocks with US centric revenues.
If you looked at our core developed Ex-US portfolio (TTAI- the TrimTabs All Cap International Free Cash Flow ETF) you would see some stocks such as Lululemon (LULU), Alibaba (BABA), and Yum China (YUMC) that are not in our benchmark. But these companies absolutely meet the criteria and objectives of the fund.
While these markets have been in a bear market, we have increased our exposure to companies with moats such as strong global consumer brands, and/or North American revenues. As active managers, we can take a step back and respond to the changing landscape in a modern and efficient manner within the parameters of our models.