In high-priced markets, there are good reasons to look for innovative companies that thrive off disruption. Many are highly valued with good cash flows precisely because they have products and services that consumers consider essential, which could bode well in a downturn.
It is hard to ignore the fact that the US equity market is trading near record highs, with the S&P 500 Index more than tripling in value since its 2009 lows and price-to-earnings multiples near all-time peaks.
While some investors are still enjoying this run-up, others worry they might hold on too long. There is of course no way to identify the best time to buy or sell, but it is important to point out that some of the largest gains in an investment cycle are left to the end. Exiting too early can mean a sizable loss of opportunity.
In addition to maintaining one’s positions, there is another approach for investors to consider late in an economic cycle such as this one: Investing in companies that thrive off disruption and create significant value for their customers. Many of these firms are highly valued precisely because they have vital products and services that consumers consider essential, which could bode well in a downturn.
Innovation drives value
Consider for a moment the productivity-enhancing high-tech innovations that powered the growth of social media, cloud computing and ecommerce. These disruptive technologies triggered an interesting inflection point that is very different from the one seen during the tech bubble, which was fueled by red ink. Today’s most innovative companies have growing levels of free cash flows and the ability to drive their own profitability expansion, which makes them that much more valuable to customers and shareholders alike.
For example, the largest social media advertiser in the world continues to add value for its customers by improving the visibility of returns for every ad dollar spent. As advertising budgets become tighter in a downturn, their clients are more likely to invest their last ad dollars in a channel that can target engaged consumers and generate sales.
Also consider the largest providers of cloud computing, who offer the opportunity to reduce costs and increase productivity without requiring their customers to invest big capital budgets behind massive data centers and enterprise integrations. This flexibility is exactly what their customers need as economic tailwinds subside, when they look to optimize costs.
Finally, the largest ecommerce company in the world continues to invest in new services to improve the value of their annual membership: music, media, free delivery, books and digital storage. So when they raised subscription prices by 25 per cent in a single year, after many years of adding content to their service, there was very little pushback from their customers even as the company enjoyed a significant boost to revenues.
The importance of active stock selection
Clearly, there are many options for managing portfolios in the later stages of an economic cycle. Shifting portfolios to more defensive sectors or cash is one traditional option, as is investing across a broad basket of securities to improve diversification.
However, given that a rapidly falling market has the ability to drag down entire asset classes, an active, focused approach may be beneficial during the late stages of a bull market. While no investment strategy can guarantee a profit or protect against a loss, investing in companies that offer differentiated consumer services and measurable returns could add the diversification investors need as the debate over market tops intensifies.
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When the European Central Bank finally shifts course, it will taper first, then raise rates – but that shouldn’t happen at the bank’s next meeting. Instead, President Draghi will likely highlight a solid euro-zone recovery while citing low core inflation as a reason not to make any major changes.