The continued rise of value stocks only means that quality stocks also continue dropping, and they have reached a new milestone.
According to a new research note issued to investors and analysts by Tony DeSpirito, the Chief Investment Officer (CIO) of U.S. fundamental equities at BlackRock Inc., higher quality stocks are trading at their largest valuation discount to the broad market since the dot com bubble of the early 2000s.
What is a Quality stock?
Since stocks are issued by companies, a company has to be of high quality in order to have its stock categorised as a quality stock. In this sense, a quality company is one that is highly profitable and has a record of stable business performance over time. This company has the financial strength to invest for the long term. With that being said, the best performing quality stocks are those that have good track records of returning surplus cashflows to shareholders mostly through dividends.
According to British multinational asset management company Schroders PLC, quality stocks are captured using three key characteristics, namely:
- Profitability – Rates of returns, particularly return on equity, cash flow generation and the margins of the business, which measure the ability of the company to generate profits from its assets.
- Stability – While profitability is a significant driver of relative stock returns over time it can be enhanced by focusing upon companies with more stable fundamentals. They analyse the growth of dividends, stability of cash flows, earnings and sales over time which helps to avoid temporarily cyclically strong companies which may easily be mistaken for sustainable growth. Moreover, by analysing a variety of largely discretionary items (e.g. accounting accruals, capital expenditure, the change in shares, the ratio of investment to assets and recent asset growth to name a few) we can also capture how management is expanding the business and its sustainability, as well as flagging potential operational risks.
- Financial Strength – Whilst some debt is fine, it is also important to distinguish between those companies that are expanding via excessive financial leverage. Companies with modest leverage and ample ability to service that debt are more likely to be masters of their own destiny. Thus Quality companies have appropriate leverage given the investment cycle, cyclicality of cash flows and opportunities to invest in high returning investments.
Surprisingly, despite the impressive fundamental features of high quality companies, you could thing their stock would greatly attract investors but this has not been the case for now nine months which makes us wonder why!
So, why are quality stocks sucking the wind?
We know the what, but to understand the why, we need to first know the when. When did investors abandon quality stocks? We find the answer in DeSpirito’s research, which has established that quality stocks started underperforming in November 2020, just after Pfizer and BioNTech announced the discovery of the COVID-19 vaccine.
After the discovery of the COVID-19 vaccines, conversations and expectations of the global economy to recover from the Coronavirus vaccine were high so you would think investors would pick up stock from those countries that had more potential of lifting their dividends and share repurchase plans because of the macro rebound). To my, and the market’s surprise, investors have largely avoided or sold quality stocks since November last year in favour of riskier bets that produced strong gains early in the recovery.
The performance of the Invesco S&P 500 High Beta ETF is great example of this dynamic. Some of the top holdings of the Invesco S&P 500 High Beta ETF include high risk bets on companies like United Airlines and Carnival Corporation and plc which are expected to hugely benefit from the economy recovery brought about by the discovery of the COVID-19 vaccine that would allow more people to travel and go on cruises.
The ETF has posted high gains of 31% year-to-date, outperforming the benchmark S&P 500 which has gained 13% in the same period. On the other hand, the Schwab U.S. Dividend Equity ETF which includes high quality dividend growers like Home Depot is underperforming the Invesco S&P 500 High Beta ETF, gaining only 17% year-to-date.
The investment seeks to track the investment results (before fees and expenses) of the S&P 500® High Beta Index (the “underlying index”). The fund, which is compiled, maintained and calculated by the S&P Dow Jones Indices LLC generally will invest at least 90% of its total assets in the securities that comprise the underlying index.
The good news..
Despite the current storm sweeping high quality stocks for nine months now, DeSpirito believes the tide is about to swing back and soon enough, they will find a smooth sailing.
“We see potential for quality to rerate higher. As the cycle evolves, the market will look ahead to more normalized growth rates, and investors are likely to grow more cautious amid concerns around taxes, inflation and the timing of a Fed policy shift,” DeSpirito explained.