Capital Ideas^™

The Cold War was raging, Jimmy Carter became the first candidate from the U.S. Deep South elected President since the Civil War, and Apple Computer was a newly established private company the year Joyce Gordon began her career at Capitals Express Investments. She started as an assistant at age 19 — the youngest employee ever hired at the firm at that time.

It didn't take Gordon long to recognize that the investment analyst role was the job to have at Capital. "For the first couple of years I was in a clerical role, but I decided pretty quickly that I wanted to work as an investment analyst," she recalls. "Portfolio managers depend on the analysts to provide the information they need to make investment decisions. And I really liked the camaraderie and mutual respect among the investment professionals."

With Capital's backing, Gordon earned her degree and then an MBA at night. In 1987 she became an analyst, covering savings and loans.

"Two years later, my responsibilities expanded to include the banking sector. That was in 1989, right before the commercial real estate crisis, when the average bank lost 67% of its value over 12 months," she says. "It was about the only group of stocks that was declining because the crisis was centered around real estate. It was a lonely existence. I remember my research director saying, 'Joyce, you are so lucky. You’re getting five years' experience in one year.'"

We sat down with Gordon to get her perspective on the current environment and lessons learned about investing through volatile markets.

The U.S. economy is firmly in late-cycle territory. How are you thinking about portfolio positioning today? Are you doing anything differently?

Now that the U.S. Federal Reserve has halted its interest rate hikes and taken a more dovish stance, I expect the decade-long U.S. expansion can continue, even though we are in the late stages of the cycle. I also feel that markets can continue to offer appreciation.

But equity markets tend to be more volatile during the late cycle. In part, that’s because order volumes start to come down — or at least level off — which increases the potential for companies to fall short of their earnings estimates. So I expect markets to be volatile going forward.

In this environment I am looking to be more defensive, focusing on established companies with a track record of generating steady revenue regardless of what is happening in the economy.

What type of companies are you looking at today that might have those qualities?

Utilities such as American Electric Power, with long-term contracts and a stable rate base, have tended to hold up well in troubled economic times. Indeed, in 2018 the utilities sector of Standard & Poor’s 500 Composite Index posted a 0.46% gain while the broader S&P 500 declined 6.24% (results in U.S. dollars).

I also look closely at defence contractors, food companies and health care companies such as AbbVie. Hormel, for example, has held up better than the market during past declines.

These types of companies tend to have low debt levels; sometimes they are net cash. And many of them pay dividends. The longer this expansion continues, the more attention I pay to dividend sustainability. Should the company decide to cut its dividend, support for the stock price could collapse. That’s what happened with a lot of companies in the Great Recession of 2008 and 2009.

What lessons did you draw from the 2008 recession and other down markets over the course of your career?

One important lesson I learned is to avoid companies with a lot of debt. Companies with significant debt service are subject to a number of challenges. For example, they may feel pressure from credit rating agencies to cut their dividend so that they can maintain an investment-grade rating for their debt issuance.

Another thing I learned is to pay close attention to what company executives and boards are doing. Take Washington Mutual, which failed during the financial crisis in 2008. Going into the crisis, the bank issued a proxy proposal that would change its management bonus structure, removing the impact of any loan losses. In other words, management was being incentivized by volume, not quality. Looking back, that should have been a telltale sign that something horrible was coming.

I don't see a lot of those types of things going on today. But some companies are issuing debt to buy back shares and pay their dividends, rather than using free cash flow. It's tempting for companies to do this because rates are so low, but it can be a warning sign.

I have also seen some companies that have typically increased their dividend every year that have yet to do so over the past year. And in many cases these have been the companies with a lot of leverage who are becoming concerned about paying down debt. We have seen that with some of the food companies. This suggests that sales growth is tougher in this late-cycle environment.

Introduced in Canada on October 31, 2018, Capital Income Builder showed resilience during the last two months of 2018 when markets were declining. Why is that important for investors?

I am always thinking about steps I can take to help protect on the downside. Capital Income Builder’s combination of dividend-paying companies, dividend-growing companies, plus an anchor of high-quality fixed income holdings, provided resilience during the last two months of 2018. Lower volatility can help investors stay true to their investment strategy over the long term.

It comes down to doing the fundamental research on individual companies. Over time we have constructed a backdrop of what has typically happened during recessions and the types of companies that have fared better than the broader market.

We go through all the scenarios and try to make sure that we are protecting on the downside while still participating in the market. The goal is to help our investors stay the course through difficult periods by reducing the amount of volatility in the fund.