In recent months, businesses that focus on e-commerce, digital payments, cloud services, and mobile technologies have demonstrated a unique form of resilience in what otherwise has been an economic catastrophe. In our view, this enhanced growth in tech suggests a continued runway for outperformance in the sector, even as the broader economy attempts to regain its footing.
During the pandemic, many technology companies have dramatically accelerated user activity and subscriber growth while companies with more traditional business models—retailers relying on foot traffic, for example—have suffered disproportionately. Amid the crisis, many digital-first companies have compressed three to four years of forecasted growth into three to four months, by our calculations.
Technology trends were already there
From an investment perspective, the pandemic has underscored certain realities about contemporary economic activity: Over time, e-commerce will take share from store-based retailers, streaming media will make linear TV programming a thing of the past, and digital activity will contribute to the growth of brick-and-mortar digital warehouses.
Digital payments, to take one example, is what we’d call a durable trend—and not only because consumers are currently leery of touching physical cash because of pandemic-related fears about contagion.
Companies in this segment haven’t been idle during the crisis. Well-known U.S.-domiciled credit card companies have recently begun to collaborate with digital payment providers well beyond our borders, linking U.S. payment infrastructure with digital consumer activity in Asia, for example. That’s a new step—but we think an entirely predictable one—in tech globalization.
Measuring company resilience with net debt to free cash flow
Many investors assess corporate strength and market trends on the basis of debt-to-capital ratios. We prefer to look closely at companies’ net debt to free cash flow. We think this metric offers a more robust measure of a company’s resilience to economic turmoil.
We want to know, for example, how many years it would take a company to pay off its debt if it used 100% of its free cash flow to pay back debt each year. As we consider roughly 1,000 stocks in each of our relevant investment universes—U.S. and international—the ratio of the median company’s net debt to free cash flow is 6x to 7x. In our portfolios, the median is closer to 3x to 4x, implying the average company in our portfolios could pay back all of its debt in three to four years. On a relative basis, we believe net debt to free cash flow offers a better signal of potential downside protection.
With the digital-focused companies we’ve been discussing, the strongest players’ competitive advantages tend to increase barriers to entry for potential rivals. We’ve also found that, over time, those barriers tend to lead to lower capital intensity, which drives higher free cash flow margins. In other words, digital-focused companies are consistently rising to the top in our overall market assessment and building on a resiliency they’ve already demonstrated through a devastating crisis.
Economic outlook: a return to growth
At Wellington, a key macroeconomic signal we use is our global cycle index—a proprietary research tool that helps us gauge our position in the economic cycle, the relative intensity of investor risk appetite, and optimal factor weights across portfolios. For example, beginning in late February, the global cycle index fell, and that argued in favor of shifting portfolio weights toward higher-quality companies with stronger balance sheets and better dividend yields. Given the amount of fiscal and monetary stimulus added to the financial system recently, we expect the global cycle index to recover as businesses reopen globally. As the index improves, we’d expect to shift to a more balanced position on measures of quality, growth, valuation, and capital returns.
The recovery is already under way, particularly in China; in fact, the recent Manufacturing Purchasing Managers’ Index (PMI) in China indicates expansion. In addition, Chinese fiscal and monetary stimulus has been very targeted, with data points such as new truck sales showing outsize growth, and we believe stimulus has been an efficient contributor to a broad economic rebound. Outside China, emerging markets continue to struggle from the impact of the virus. Because many of these countries lack the healthcare infrastructure needed to manage the crisis, we believe the shutdown will continue to weigh on growth rates in the medium term.
While this is an unscientific observation, we believe that Chinese and North American companies have demonstrated a predilection for business development driven by disruptive technologies and technological solutions. On the other hand, Europe remains more focused on traditional businesses, perhaps as a result of lingering issues in its decade-long sovereign debt crisis, its fiscal disunity, and the country-bound nature of its banking system. These traditional businesses include telecommunication services, wireless, fixed-line service companies, consumer staples, and banks—all of which tend to grow at slightly lower rates and have more competition.
For this reason, we see North America and China as inherently better positioned over the short term to return to growth more quickly than other areas around the globe. Indeed, we see tech companies pointing the way to growth, with their acceleration moving at roughly twice the rate of the rest of the market. Viewed from this perspective, we think the outperformance of the FAANGs (Facebook, Amazon, Apple, Netflix, and Alphabet (parent company of Google)) and other digital-first companies in e-commerce and cloud-based ecosystems is more likely to continue while most other sectors are just getting back on their feet.