How to Manage Coronavirus Fears

COMMENTARY 2/4

genome sequencing and other medical breakthroughs are allowing leading companies to disrupt business practices and even entire industries. In the process, innovative companies are growing their earnings by capturing market share as shown by the example of the massive migration of information technology from on-premises to the cloud.We believe disruption is a highly durable trend, as illustrated by internet advertising and e-commerce revenues growing approximately 30% during the Global Financial Crisis even though total retail sales were virtually flat (See Figure 1). Economic Moats: Helping to Create Durable Earnings Growth Economic moats are characteristics that can protect companies from new competitors. The costs or difficulties of clients switching from one product to another, for example, can help firms fend off competitors. Other moats include the network effect (or the value of a product increasing as more people use it), intangible assets (brand identity, government licenses and patents), cost advantages (producing goods at a lower cost than competitors) and efficient scale (average unit cost declines as production volume increases), according to Morningstar. Companies with strong moats have outperformed over numerous time periods (See Figure 2). 17.82 14.54 7.28 14.49 12.37 6.79 14.91 13.97 11.67 15 20 Strong Balance Sheets Companies with low debt costs relative to income (debt-service ratios) may be well positioned to tolerate economic headwinds. Low debt-service ratios give 0 5 10

Figure 2 Wide Moats, Wide Opportunities (%)

Morningstar Wide Moat Index Morningstar No Moat Index S&P 500 Index

17.82

14.91

14.54

14.49

13.97

12.37

11.67

7.28

6.79

Performance

5 Years

3 Year

10 Years

Source: Morningstar, Inc. as of 1/31/20. Note: Returns for greater than one year are annualized.

companies flexibility to weather economic volatility. By contrast, companies with high debt levels may not be in control of their own destiny as they must service and repay bondholders even if it means cutting back on critical spending. Not doing so could result in bankruptcy restructuring at the expense of shareholders. Having a strong balance sheet can mean the difference between enduring to fight another day and not being able to survive a crisis. During the bear market of the Global Financial Crisis, which lasted from October 2007 until November 2008, companies with high levels of debt underperformed the broad market, as indicated by the Axioma leverage factor, by more than 10 percentage points.

Figure 1 Innovation Can Triumph Over Economic Volatility

140

U.S. Internet Ad Revenue U.S. E-Commence

130

120

+30% Growth

110

U.S. Total Retail Trade

100

90

80

Q211

Q208

Q308

Q408

Q109

Q209

Q309

Q409

Q110

Q210

Q310

Q410

Q111

Source: Bureau of Economic Analysis, PwC, Census Bureau.