Back in the doldrums of the bear market, we repeatedly stated that the downturn was cyclical, not secular, meaning that we believed the economy had not undergone a structural, systematic change, but instead was simply at a stage albeit an unpleasant and prolonged one in the historic ebb and flow that is the essence of market economies. With an investment philosophy grounded on the importance of seeking to remain fully invested while managing risk consistently throughout all phases of the market cycle, we positioned each of our strategies accordingly. A review of how we got here lends insight to where we might be going.
Broadly speaking, our outlook translated into a de-emphasis of some consumer-dependent businesses while re-emphasizing companies that would benefit from business capital spending. When the markets took off early this year, the surge was sustained only by investor's recognition of the forthcoming economic recovery. At that time, much attention was paid to the effect a new round of tax-cuts would have on the consumer and his or her spending habits, as the debate centered on short-term effects of such spending (or the lack thereof). As we noted at the time, the tax cuts would have a profound effect on the economy, but we were less interested in the short-term debate and more focused on the long-term effects that such cuts would have on businesses, investors, and their ability to build wealth.
Now, only a few quarters later, it appears clear that the impact of the tax cuts on dividends, capital gains, high-income earners, and especially the allowance of speedier business depreciation write-offs for new equipment purchases, are much more significant than a one-time cash rebate. Today, the after-tax cost of capital expenditures makes investment in capital goods more attractive for businesses and the after-tax returns more attractive for investors. The result has been rises in business spending on equipment and software, top-line growth, and profits. With improved cash flows, cheap access to capital, greater productivity, and lower inventories, we believe industries that benefit from capital expenditures will enjoy a tailwind as business sentiment continues shifting the use of debt from improving balance sheets to investing in growth.
While the market has recovered nicely, questions remain, as certain economic indicators contradict each other regarding the health of the economy. Its important to note the distinction, however, between the extent of the bear market and the downturn in the economy. The former was more severe and largely caused by overextended valuations, yet the latter was actually quite mild, as consumer spending made the recession one of the shallowest on record. Assessing the economic cycle by the depth of the markets decline or the speed of its recovery creates false impressions of both the economy's downturn and its revival. Although the market is clearly recognizing the economic rebound, history has demonstrated that mild recessions undergo mild recoveries, requiring patience by investors. Rather than expect a rising tide that will raise all boats, we believe that the slow emergence of the economic recovery will result in a period where bottom-up security selection will trump broader index bets, and we are utilizing our research capabilities accordingly.
Among Equities
We've noted above our unwillingness to chase the market, as we have little concern for short-term market movements provided we feel confident that we have properly identified the current phase of the economic cycle, and can thus anticipate the next stage, whenever it may occur. For example, now that low interest rates and abundant debt issuance has enabled companies to improve their balance sheets, the emerging stage of recovery involves using debt to invest in growth. While the equity markets are currently focused on economically sensitive value stocks, the next phase of a recovery should see the return of investors favoring growth companies as the economic recovery matures. Other examples of trends that we are anticipating will confirm an ongoing expansion include a revival of the IPO market and a rise in merger and acquisition activity. Because we are confident of the cyclical nature of the markets, we can plan accordingly by understanding where we are in the market cycle.
Among High-Yield Bonds
Similarly, in our high-yield strategies, our assessments of the current and upcoming stages of the economic recovery have shaped our investment approach. In addition to weighting sectors as discussed above, our focus earlier in the year was on industries that stood to benefit the most from a narrowing of credit spreads. Now that the narrowing has occurred (delivering sizable gains in the process), we are instead relying on our intense research process to identify individual securities that stand to benefit most from an improving economy, whether from a credit-rating upgrade, merger activity, or other special situations. This shift demonstrates not only our ability to properly react as a business cycle unfolds, but also our willingness to combine both top-down and bottom-up research and analysis.
Among Convertibles
Our focus on maintaining an appropriate balance between risk and reward throughout the market cycle currently places us at a disadvantage when compared with the broad convertible market. That's because a great deal of convertibles now rate as below-investment grade, with an inordinate amount actually qualifying as purely speculative, lacking sustainable fundamentals. Although our intense credit analysis enables us to confidently wade into lower-tier companies, we strive to not overexpose ourselves to such risk and will only invest in companies that we believe can survive, even if the recovery stumbles. This approach to consistently managing risk means that we will not get as risky as the index, and will miss some participation when bankrupt and near-bankrupt names rally. We experienced similar short-term underperformance prior to the markets bubble as the index became much too exposed to equity downside for our approach, and we were amply rewarded for such caution over the longer term. We remain confident that our limited exposure to an overly risky market will prove valuable once again.