Look how leverage juices returns in a strong market

Author: Bob Gay, GEARS

Covestor model: Speedboat

The Speedboat model’s investments are focused on higher growth and accelerating companies. This is typically a small population, since to sustain high and rising rates of growth for long periods is very difficult. We are capturing companies during the acceleration phase of the growth cycle and making buy decisions for depressed shares. To find high and rising growth combined with depressed shares is very rare, but the weak stock market in the month of September produced many opportunities.

By early September the Speedboat model was fully invested and leveraged. Short of acquiring yet more leverage, my options were limited by the model strategy and returns suffered a sharp decline in late September. The stock market rally in October had the anticipated powerful effect on the Speedboat returns, indicating the value of high growth and leverage in a stronger stock market.

The analysis of second quarter financial statements suggested that the recovery leadership was shifting from consumer durables spending to capital goods spending. There was no evidence of an overall peak in fundamentals. Still, the combination of increased perceived risk of stocks and fears of a slowdown in growth took share prices and bond yields to new lows in September. Here is a brief recording I made with a review of the second quarter numbers.

The third quarter financial statements that we have collected so far support our contention that despite all the concern about macro-economic weakness, companies continue to accelerate. With financial condition improved, companies are beginning to increase capital expenditures. We have seen this cyclical pattern before from U.S. companies and using history as a guide, the next few years will likely bring strong corporate growth, higher commodity prices, higher inflation and rising interest rates. Assuming the capital goods driven cyclical advance unfolds as it has in the past, the peak will be evident in early 2013. We anticipate stocks will be 30% higher and long bonds will be 20% lower. Of the major asset classes, only stocks will produce an acceptable return in the late cycle scenario.

Fortunately we do not have to make decisions on such blind faith. In the next few weeks all public companies will deliver financial statements for the third quarter and we will have a clearer picture of the path of corporate growth. Over 50 years of data experience shows that we should be able to observe the peak in corporate growth when it appears. Sales growth will fall, costs will rise and inventories will increase.

For now we are in the acceleration stage of the corporate growth cycle. Even after the October rally, shares are still depressed and we believe investors should be increasing exposure to stocks and reducing investments in fixed income securities.

What constitutes high growth is a function of the growth rate of the average company. In the past year, American companies produced average sales growth of 15% and cash flow growth higher than that. This places the growth bar very high. Although the population of companies that clear the bar is quite large as we trace out the acceleration phase of the cycle, finding depressed shares in that high growth population is rare. Still, share price volatility helps in the search and as the new third quarter financial statements appear in the next few weeks I will be adjusting the Speedboat model portfolio to press the exposure to the higher growth companies.