Equity investors have had a turbulent time over the past 15 years, including a dotcom boom and bust, the financial crisis in 2008 and the rise and fall of the mining sector. So it is hardly surprising that they have become a little choosy about the stocks they favour. Orrin Sharp Pierson, a strategist at BNP Paribas, points to a huge preference among investors in recent years for “quality” stocks. He defines such stocks as those with the least volatile profits. As the chart shows, when the market was bottoming in late 2008 and early 2009 there was little difference in valuation between high-quality and low-quality companies. But the gap has widened steadily ever since. Quality stocks now trade at around 3.5 times their book (or asset) value.
Of course fund managers are unlikely to tell clients they are investing in rubbish stocks. The quality label is highly flexible: not everyone defines it in the same way. Andrew Lapthorne, an analyst at Société Générale, identifies quality stocks as those that pass a series of financial tests known as the “Piotroski F-score”. On this measure, which includes things like cashflow and changes in leverage, Mr Lapthorne thinks quality stocks have generated a return double that of global equities since the dotcom bubble peaked in 2000.
There are a number of explanations for why quality stocks, however defined, might be outperforming. The first is diversification. Multinationals like Procter & Gamble or Nestlé are not exposed to a single economy but sell their products around the world. Not only can they benefit from the growth potential of developing economies, they also have some protection against tax increases or regulatory changes in the developed world.
A second (and related) factor is resilience whatever the growth environment. Six successive quarters of falling output in the euro zone have prompted investors to reward companies with profits that are relatively immune to the economic cycle.
A third explanation is balance-sheet strength. Companies that are sitting on sizeable cash piles have the ability to return money to income-hungry investors in the form of dividends or share buy-backs. That gives them an appeal in a world where government finances look shaky and bond yields are at historically low levels. In effect, investors are buying quality equities as proxies for bonds—relatively secure assets with added protection against the risk of higher inflation.
The stockmarket is highly prone to fads for one type of stock or another. In the 1960s and early 1970s the popular play was to invest in the “Nifty Fifty”, which comprised large companies such as Coca-Cola and General Electric. These businesses were so reliable that investors felt they could buy them regardless of valuation. They were “one-decision” stocks that could be bought and locked away in a drawer. The result was a bubble that burst in the middle of the 1970s.
Is something similar happening today? Quality stocks may be doing so well because they are relatively scarce. Peter Oppenheimer, a strategist at Goldman Sachs, finds that only 15% of European companies are expected to have sales growth of 8% or more over the medium term, compared with more than 40% of companies at the turn of the millennium. Mr Lapthorne finds that only 2% of all stocks in the FTSE World index both meet his quality criteria and have a dividend yield of 4% or more. This is close to the lowest proportion that has been seen in the past 20 years.
The boom in quality stocks may still have further to run. Anthony Hene at GMO, a fund-management group, says that European quality stocks look overvalued but the American ones still appeal. Yet the shortage of quality stocks points to a problem for the wider market.
Investors have been flocking to equities because interest rates are so low; some, perhaps, on the naive view that using a lower discount rate on future cashflows translates into higher share prices today. However, interest rates are low because economies have been sluggish and central banks are worried about the prospects for future growth. In a low-growth world, future cashflows from equities will be smaller than previously expected. The bulls are changing one part of the valuation equation but not the other.
Mr Lapthorne’s research shows that in the past, periods when higher-quality, higher-yielding stocks have been scarce have led to disappointing returns from equities. The really bullish conditions for equities will be satisfied when (or rather, if) growth returns to pre-2007 levels and a lot more stocks pass the quality test.
Disclosure: this article is distributed for educational purposes only, and it is not to be construed as an offer, solicitation, recommendation, advice or endorsement of any particular security, product, or service. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed.
Leave a Reply
You must be logged in to post a comment.