Equities To Target In The Late Expansion Phase

When it comes to investing, timing is crucial, and understanding the economic cycle is key to making the right decisions. As the economy goes through different stages, from expansion to contraction, investors need to adjust their portfolios accordingly. Late expansion is a critical phase, and choosing the right type of equities to invest in can make a significant difference in the potential returns. This is the time when investors look towards defensive sectors and inflation-protected categories, aiming to safeguard their investments and prepare for potential economic shifts.

Defensive and inflation-protected categories

Defensive stocks are shares in companies that provide consistent dividends and stable earnings regardless of the state of the overall stock market. They are also known as non-cyclical stocks because they are not highly correlated with the business cycle. Well-established companies such as Procter & Gamble, Johnson & Johnson, Philip Morris International, and Coca-Cola are considered defensive stocks. These companies have strong cash flows and stable operations with the ability to weather weakening economic conditions.

Defensive stocks tend to perform better than the broader market during recessions but often perform below the market during an expansion phase due to their low beta or market-related risk. They are less likely to face bankruptcy because of their relative strength during downturns.

Examples of defensive stocks include water, gas, and electric utilities, as people need them during all phases of the business cycle. Companies that produce or distribute consumer staples or goods that people tend to buy out of necessity are also generally considered defensive stocks. These include food, beverages, hygiene products, tobacco, and certain household items.

Another defensive sector is healthcare. There will always be sick people in need of care, and healthcare companies are therefore considered recession-proof. However, they are not as defensive as they once were due to increased competition from new drugs and uncertainty surrounding regulations.

Apartment real estate investment trusts (REITs) are also deemed defensive because people always need shelter. However, it is recommended to steer clear of REITs that focus on ultra-high-end apartments, office buildings, or industrial parks, as these could see defaults on leases rise when business slows.

Inflation-protected categories include gold, commodities, various real estate investments, and TIPS (Treasury Inflation-Protected Securities). Gold has often been considered a hedge against inflation, particularly in countries where the native currency is losing value. Commodities are also considered an indicator of inflation to come; as the price of a commodity rises, so does the price of the products that the commodity is used to produce.

Real estate works well with inflation because, as inflation rises, so do property values and rental income. For this reason, real estate income is one of the best ways to hedge an investment portfolio against inflation.

TIPS are a type of U.S. Treasury bond that is indexed to inflation. Twice a year, TIPS pay out at a fixed rate, but the principal value changes based on the inflation rate, so the rate of return includes the adjusted principal. TIPS come in three maturities: five-year, 10-year, and 30-year.

Venture capital investors

Late-stage venture capital is a critical growth phase in a startup's lifecycle, where companies move beyond proving their concept to scaling their operations and preparing for significant milestones like an IPO or acquisition. Late-stage funding targets companies with:

• Significant revenues: Companies at this stage often generate millions in annual revenue, showcasing operational strength and market acceptance.
• Mature products: Products or services have already been tested, refined, and validated in the market.
• Clear scalability: A roadmap to expand operations while maintaining or improving efficiency and profitability.

• Scaling operations: Funding at this stage is often used to increase production capacity, enhance technology infrastructure, or expand into new markets. Investors should assess the company's ability to effectively utilise funding to scale their operations.
• Driving innovation: Access to capital allows companies to invest in research and development, improving their offerings and staying ahead of competitors. Venture capital investors should evaluate the company's commitment to innovation and its potential impact on future growth.
• Workforce expansion: Late-stage funding supports hiring efforts to build robust teams that can manage growth and operations at scale. Investors should consider the company's ability to attract and retain top talent, as well as the overall strength of the leadership team.
• Strategic acquisitions: Companies may use capital to acquire complementary businesses or technologies, accelerating growth and gaining a competitive edge. Venture capital investors should assess the strategic fit and potential synergies of such acquisitions.
• Market positioning: With increased resources, businesses can implement aggressive marketing and sales strategies to dominate their industry. Investors should evaluate the company's go-to-market strategy and its potential for capturing market share.
• Due diligence: Conduct extensive due diligence on the company, including evaluating financial health, market traction, and the leadership team's ability to adapt to challenges.
• Risk management: Identify and address potential risks, such as market, operational, financial, and strategic risks. Develop a proactive risk management framework to safeguard the investment's value.
• Exit strategies: Consider the timing and approach for exiting the investment, such as through an IPO, merger, or acquisition. Late-stage investments typically have holding periods ranging from 3 to 7 years, and investors should aim to maximise returns while navigating challenges.
• Portfolio optimisation: Actively manage the investment portfolio to adapt to changing market conditions and ensure alignment with strategic goals.
• Partnerships: Foster strategic partnerships to enhance the portfolio's growth and resilience. Collaborate with other investors or industry experts to mitigate risks and maximise the potential for long-term success.

Growth funds

During the late cycle, economic activity often reaches its peak, implying that growth remains positive but is slowing down. Rising inflation and a tight labour market may crimp profits and lead to higher interest rates. The late cycle has historically lasted an average of a year and a half, with the overall stock market averaging an annualised 5% return. As the recovery matures, investors shift away from economically sensitive assets.

Growth equity investors provide expansion capital for companies with positive growth trends, proven business models, and that need more capital. In exchange for acquiring minority ownership stakes in late-stage companies, investors gain from the high-growth potential and moderate investment risk. Growth equity managers add value in terms of revenue growth, enhanced management, margin improvements, and exit planning.

The late cycle is one where defensive and inflation-protected categories are sought, such as materials, consumer staples, healthcare, utilities, and energy. This stage is simply a slowdown from the higher growth period of the mid-cycle—it does not mean that the economy is experiencing negative growth, it just means it is no longer growing at the same pace. The return historically has been less, on average about 5%.

Private equity funds

During the late expansion stage of the economic cycle, investors tend to look for defensive and inflation-protected categories, such as materials, consumer staples, healthcare, utilities, and energy. Private equity funds can play a role in this stage by investing in companies that exhibit high growth potential and helping them expand their operations, develop new products, or restructure their management and operations.

• Investment strategy: Private equity funds seek out companies with high growth potential, often in industries like software, consumer discretionary, and healthcare. They provide the necessary capital to fuel expansion, disrupt existing markets, and establish defensible market positions.
• Value creation: Private equity firms focus on adding value to their portfolio companies during the investment period. This includes operational transformation, such as developing new products, expanding to new markets, and increasing efficiency through restructuring. They also assist in team development, helping make new management hires, and offering training and upskilling programs.
• Buy-and-build strategy: Private equity funds may employ a buy-and-build strategy, where they acquire a "platform" company and then make multiple "add-on" acquisitions to expand horizontally and vertically. This approach creates value by increasing scale and resulting in a final valuation greater than the sum of its parts.
• Multiple expansion: Private equity firms aim to enhance the public perception of their portfolio companies to increase their exit multiple. They achieve this by improving the company's growth narrative, lowering its risk profile, and enhancing its visibility in the marketplace.
• Deleveraging: While less common in modern deals, private equity firms can also improve the cash flow of a portfolio company by paying down debt, thereby increasing the company's net value over time.
• Risk considerations: Private equity investments during the late expansion stage carry execution risk, which refers to the potential failure of the investment plan. Additionally, mature companies targeted by private equity firms may faceincreased market disruption risks and external competition.

Differentiation and disruption

Differentiation

Differentiation is about setting yourself apart from competitors and establishing a unique position in the market. In the context of equity investments, differentiation can be applied in several ways. Firstly, investors can seek to differentiate their portfolios by including a diverse range of equity investments across various sectors and industries. This diversification not only reduces risk but also allows investors to take advantage of different economic cycles and market trends. For example, during the late expansion stage, defensive sectors such as materials, consumer staples, healthcare, utilities, and energy tend to be favoured. Differentiation can also be applied at the company level. When investing in late-stage companies, investors often look for unique business metrics, sustainable practices, and a strong potential for longevity. This involves evaluating factors such as unit economics, market trends, and the company's ability to disrupt existing products or services in its industry.

Disruption

Disruption, in the context of investing, refers to the introduction of innovative products, services, or business models that significantly alter the way an industry operates. Disruptive companies challenge the status quo and often experience rapid growth by addressing unmet needs in the market. When investing in equities during the late expansion stage, it's important to identify companies with disruptive potential. These companies typically have established business models, proven product-market fit, and repeatable customer acquisition strategies. They are focused on growth and market capture, and they may require additional capital to reach their full potential. Late-stage investors, such as growth equity firms, play a crucial role in helping these companies sustain or accelerate their growth trajectories. By investing in late-stage companies, these investors contribute to further disruption and market establishment.

The late expansion stage presents unique opportunities for investors to leverage differentiation and disruption to their advantage. By understanding these concepts and applying them strategically, investors can make more informed decisions about which equities to invest in during this specific phase of the economic cycle. It's important to note that market dynamics and economic conditions can vary, and investors should always conduct thorough due diligence before making any investment decisions.

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