Quality stocks offer an appealing combination of defensive characteristics and potentially superior returns, but valuations are driven by greed and fear
Recent market vulnerabilities have got many investors rethinking their exposures. What role do defensive assets play if interest rates rise? Is the downside risk unpalatable? Could it be better to seek safety in higher quality stocks?
Of course, an investing nirvana rarely exists. We all want to fill portfolios with fundamentally sound assets that have high prospective returns and very low risk. However, they are rarely so obvious.
With this in mind, it is important to agree on a consistent framework to assess quality stocks. We have a clear preference to define quality as the certainty of future cash flows, which differs from some of the varying definitions in the industry.
This implies that return-on-equity may be a robust measure of quality (see chart 1), although it is not always the case and one should be careful to be so definitive. As an example, companies can appear highly profitable by having low equity book values, plus can also be a synonym of high leverage.
So, getting to terms with the definition of quality is paramount, as many external managers tout “quality growth” in different ways.
When considered in a forward-looking context, this presents an interesting dilemma, so, our ambition when contemplating the validity of quality must be far more refined.
Specifically, we want to assess whether higher quality companies could offer superior reward for risk. To do this, we must keep valuation at the forefront of our minds. We also want to understand whether higher quality companies are subjected to behavioural cyclicality and how they interact with other assets during times of stress.
The performance profile clearly depicts that quality stocks share a lot in common with other stocks. As a general observation, they are positively correlated across the cycle and largely move in sync with other stocks, with the apparent benefit of protecting capital in downturns. In this sense, the historical evidence is supportive.
Yet, everything has its price and valuation pressures can manifest anywhere. For instance, quality stocks have excelled relative to market cap equivalents more recently (see chart 2), causing some concern about whether the outperformance over the past decade is sustainable.
Regardless of how you dice it, quality companies are unlikely to be immune to the investment cycle. As the historical drawdown analysis shows, they are susceptible to loss too (see chart 3). The question for investors is whether the attractive characteristics of quality companies are being overwhelmed by unattractive valuations, which in turn, can lead to greater losses. Said simply, we need to understand the return potential across a wide range of outcomes.
This also needs to be balanced when we assess the prospective drawdown protection that a quality bias might offer, as it could differ significantly from historical patterns.
Of course, looking in the rearview mirror is easy, but it can unearth some behavioural clues to help us assess the opportunities for this part of the markets.
For instance, we find the quality basket could be driven by a few key factors. First, one should be aware that quality stocks tend to be heavily influenced by US equities generally (they account for approximately 70 per cent of the world quality basket). Furthermore, technology stocks are also prevalent in this space, accounting for around a third of the total exposure. When you put these two together, it should not be a surprise that the quality basket has done well in recent years given the tailwind from these two exposures.
Investors’ want to source high quality investments for their defensive attributes, but simultaneously find that some of the biggest relative overweight positions (such as technology stocks, especially among US equities) appear grossly overvalued relative to longer-term averages.
So, how does one split these two potentially contradictory points? One way of sidestepping the problem is to look at the quality landscape from a country or regional level. This allows one to look through some of the concentration issues and focus on the more attractive areas of the market.
We use “valuation-implied returns” to compare opportunities and inform the discussion. This tells us how much one could expect to earn from underlying opportunities on the assumption that prices return to fair value over a 10-year period. Using this approach as a starting point, quality stocks still appear much more attractive than their market-cap weighted counterparts, highlighting possible pockets of opportunity (see chart 4).
Opportunity in Europe
This relative opportunity appears to be especially pronounced in Europe, with the quality valuation-implied return exceeding the European market-weighted equivalent by more than 1.5 per cent per annum.
Quality exposures in emerging markets also appear to offer attractive valuations relative to the market-weighted equivalents, although Japanese quality appears to be expensive in both absolute and relative terms.
Quality stocks therefore offer an appealing combination of defensive characteristics and potentially superior long-term returns relative to market-cap equivalents.
However, like any single asset, they are unlikely to be a complete solution for portfolio builders. These stocks remain subject to investor sentiment, with fear and greed driving valuations. Hence, the notion of quality is at its most exciting when other investors abandon a stock for something more alluring.
Dan Kemp is chief investment officer at Morningstar Investment Management Europe