Think the Fed is going to cure the virus or save the stock market? Think again.
There is a bigger problem that is likely to persist long after the virus pandemic is over: low-quality cash flow, according to Robert Almeida, global investment strategist at MFS. It's an out-of-consensus view for the market's retreat in recent days, but many shrewd investors have voiced questions about the quality of profits these days.
In a recent paper, Almeida wrote that the coronavirus simply spotlighted a problem that has existed for several years. It’s the realization that “investors have been paying an above-average price for below-average return potential,” he declared.
Deteriorating fundamentals have been an argument that many like Mike Wilson at Morgan Stanley and Richard Bernstein of the eponymous firm have been making for several years. Stocks are being propelled by buybacks, low interest rates and cuts in corporate tax rates—everything but organic growth and solid fundamentals. A change in the occupant of the White House could reverse the corporate tax cuts, for example.
Sooner or later, that reality was bound to dawn on investors. Even before equities began to swoon in February, U.S. equities valuations were in the top quintiles. The same goes for global “investment-grade and high-yield bond spreads,” Almeida wrote.
Investors “must weigh the quality” of the cash flow stream that a business promises to generate against “the potential for an undesirable outcome,” Almeida wrote. “As a cycle matures and confidence grows, the supply of investment opportunities is at some point unable to meet the demand from return-hungry investors.”
He went on to say that more companies have been relying on creative accounting, while fewer have been driving margins and cash flows through normal business operations. It may have taken the virus to trigger financial asset repricing, but it was overdue.