The quality stock conundrum – The Australian Financial Review

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Harvey Norman has been identified by UBS as a quality company with improving fundamentals.

The strong run in so-called quality stocks is, paradoxically, a sign of trouble ahead.

Thanks to his trusted partner Charlie Munger, Warren Buffett had an epiphany in his education as a value investor. Expensive stocks – not just cheap ones – could be undervalued because their qualities weren’t being fully appreciated.

And as Berkshire Hathaway grew to such a size that it had tens of billions of dollars to deploy, he simply could no longer limit himself to discarded “cigar butts”.

So began the quest for quality companies.

But what is a quality stock? It is typically a share in a business that delivers reliable profits that can be predicted with more certainty by investors. There are other ingredients such as profit margins, financial health and volatility.

A strategy of buying quality stocks sounds simple and logical – but there’s a price for everything.

The evidence is that, even as quality stocks have outperformed the broader market, they’re under-appreciated by investors.

Less volatile

The numbers show that quality stocks hold up far better than poor quality stocks in down markets, and they hold their own in bull markets too, whilst being less volatile.

“In other words, low quality companies are seldom worth owning,” write the UBS global quantitative research team that has published a detailed paper on quality stocks.

In theory, such a strategy should not work as well as it does. The quality premium should adjust upwards relative to low quality stocks so their performance does not persist.

The quality anomaly exists for two reasons, UBS argues.

One is that quality stocks have a low beta (which means they are less correlated to the market than low quality stocks which are highly correlated) so active managers fear trailing their benchmarks if they own too many quality stocks.

The other is that there are behavioural elements at play – investors “persistently under-estimate the earnings persistence of high quality firms and tend to assume mean reversion in their estimates,” UBS argues.

In other words, investors tend to underestimate just how good these companies are.

At the moment, however, quality stocks have never been more expensive – and are tracking at historically high premiums relative to low and neutral quality stocks on a price to book metric.

For that reason, UBS is advocating that investors focus more on quality companies with improving fundamentals, a subset of stocks that is relatively inexpensive.

Quality scores

In Australia, their models have identified a handful of miners, retail and energy firms that are showing improvements in their quality scores.

In particular, they are Harvey Norman and Super Retail Group in retail, Rio Tinto, BHP and Fortescue in mining and Whitehaven Coal and Woodside in energy

Whitehaven has the highest free cash flow yield of 19 per cent and also scores high in terms of improving fundamentals. Super Retail Group, with an 8 per cent free cash flow yield, also screens well for improving quality, while Harvey Norman and Rio Tinto score highly in terms of value and improving quality.

Rounding out the list are Sirtex and Aristocrat.

In the US old tech stocks such as Microsoft, Intel and Cisco screen well, as do healthcare giants Pfizer and Bristol Myer Squibb.

In outlining why active managers should have more faith in quality, UBS has cited research that showed analysts add 2 per cent per annum in returns from correctly forecasting cash flows, but then give back almost half of that by using incorrect interest rates to discount those cashflows.

If, however, investors focused on companies whose quality was improving, their cost of capital should fall, negating the inability to work out the appropriate rate to discount those cash flows.

The topic of quality stocks and their qualities was also raised recently by Jeremy Grantham, the famed hedge fund manager who authored a widely circulated note on the stock market’s melt up last week.

Sticking to the good stuff

What has been noticeable about the recent stock market surge is that the dull “quality” stocks (which one would expect to do better when investors are cautious, but worse when they are exuberant) have actually done far better than junkier and more volatile stocks.  

Since December 2016, an index of “quality” US stocks is up about 30 per cent while “junk” stocks are up 13 per cent. The S&P 500 has gained 20 per cent.

On a relative basis at least investors aren’t losing their heads and are sticking to the good stuff.

But ironically this is one of the few characteristics of this current bull run that worries Grantham, the authority of investment bubbles.

There are several well known indicators of market bubbles, such as high valuations and accelerating price gains. But Grantham says he’s identified two more. One is “concentration” – when more money follows a shrinking group of winners.

The other is the “outperformance of quality and low beta stocks in a rapidly-rising market”.

The run in “quality” stocks has been strangely evident in 1929, 1972 and 2000.

So why should the market favouring good companies over bad ones be a sign that the market is about to blow up? (If anything a market favouring junk stocks should be exuberance.)

Avoid the full extreme

Grantham believes the logic here is that towards the end of a runaway bull market cautious investors feel that they cannot afford to sit on the sidelines. But they can’t bring themselves to buy risky stocks so find middle ground in defensives.

And while they get hurt if a correction comes, they do avoid the full extreme of it.

The experience of 1972 warrants special attention given it was the era of the “Nifty Fifty” when investors piled indiscriminately into blue chip stocks, leading them to trade at a 50 per cent premium to the market.

“Most compelling for me is that this was the very first time since 1929 that high-beta stocks were soundly beaten as the S&P 500 rose significantly,” Grantham wrote.

“And the 1972 high ushered in by far the biggest stock market decline since The Great Depression.”

It is worth clarifying that Grantham isn’t arguing against the virtues of investing quality stocks. He is just pointing out their out-performance” is an “odd signal that has done a great job” of predicting stock market bubbles.

If anything, the market is acting rationally by loading up on defensive stocks with a correction looming. But that won’t protect investors in absolute terms (in 1929 investors holding quality stocks lost 80 per cent of their money rather than 95 per cent).

The broader debate is whether “low volatility” stocks will continue to deliver better returns, relative to investment risk, than the broader market. It comes as billions are flowing into passive and smart beta strategies that target low volatility stocks.

Structural forces

Low bond rates have fuelled a rise in the so-called bond proxy stocks because investors are confusing “momentum with value and low volatility with quality“.

The long-running low volatility trade could have a while yet to run, UBS argues. There are three structural forces in place – demographics, low interest rates, and index and low volatility investing.

“Developed world populations continue to age and baby boomers continue to retire demanding low-risk, income producing equities,” UBS said.

Global growth, and therefore interest rates, will also stay low “as baby-boomers exit the workforce, taking with them their labour, capital and productivity.”

Meanwhile, there’s no sign that demand from investors for low cost funds with low volatility is slowing.

“There certainly don’t seem to be any short term drivers for a reversal in this trend.”