Quality: Why It Still Matters
From last October’s lows, the total value of stocks in the United States is up another $10 trillion. Sitting near $55 trillion, the U.S. stock market is now within a stone’s throw of record high valuations. At the same time, profits and profit margins for the largest public companies in the S&P 500 index are also at levels not seen before. There are few signs of stress in financial markets, despite much handwringing over the Federal Reserve’s (Fed) next move. If there were real concerns that high interest rates were about to sink the economy, it is highly unlikely that investors would only demand a miniscule 1.40% additional yield for corporate bonds versus Treasuries. In fact, we have seen cases recently where high-grade corporate bonds traded with yields below the benchmark Treasury bond yield. There simply does not seem to be much fretting going on among investors in risk assets.
For some further perspective, we offer the following simple table. As you can see, the value of stocks has been on an upward rise for most of the past twenty years. These gains were directionally consistent with growth in the economy and underlying corporate earnings power. The United States provided an excellent environment for wealth creation over this time, despite setbacks including a major financial crisis, pandemic, and unfolding geopolitical risks around the world.
A Weather Eye for Risk
But we would be wrong to assume that, just because the past has been generous to stock investors, that risk has been vanquished. The fact that good things have happened in the past does not guarantee that we will not suffer recessions and various unexpected crises in the future. Of course we will, and we need to prepare for that eventuality. This is why we focus heavily on “quality.” Qualities like durability and flexibility go a long way when growth is challenged and clouds overtake the economy. So, yes, we will continue to place a higher premium on things like consistency and strength of a company’s balance sheet, even at the expense of flashy growth or a high dividend yield.
Please look at the charts below. They showcase two indices we have developed to track the performance of “High” versus “Low” quality stocks. Companies with more profitable assets, lower debt, consistent operating performance, and more predictable stock price movements are in the “High Quality” bucket, while companies with opposite traits inhabit the “Low Quality” bucket. You should know that the “Low Quality” companies do offer a higher dividend yield and are cheaper by some metrics. According to Bloomberg, the lower quality stocks are priced with a dividend yield over 3%, for example, while the “High Quality” stocks’ dividend yield is only 1.6%. The lower quality stocks also trade at a lower multiple of “book value” or “book equity” than high quality. The price-to-book ratio for low quality is 1.7x while the same ratio for high quality is 7.0x. If you are looking for cheaper, higher-yielding companies, you would be well advised to look at the low-quality group. Be warned, however, that doing so generally comes with higher risk.
Please also note that the two quality groups have been in a back-and-forth “horse race” over the past couple years. There has been no significant difference between the returns of the two groups over this period. However, one should also recognize the significant difference in volatility between the two indices in the bottom chart. The lower quality stocks exhibit far greater volatility, which can be something of a problem during more challenging times than what the market currently is pricing in today. Accordingly, we try to avoid the temptation of buying cheap, higher yielding, lower quality stocks, focusing exclusively on companies with greater stability and fundamental strength. In this way, we hope to benefit from the more defensive characteristics that tend to come with more profitable, less indebted, more predictable businesses when uncertainty arises in the markets.
WCA High vs. Low Quality Index Returns
July 2021 – March 2024
WCA Barometer Update
Although it is impossible to always accurately predict when markets will turn one way or another, it does not stop us from trying.
To this end, we offer the “WCA Barometer” as one way we seek to watch for changing tides. Originally a checklist of key data, we have spared our readers an exhaustive amount of reading by consolidating our findings from a wide range of indicators into a single chart. The chart below shows our barometer, and it continues to point in a generally positive direction. For the most part, growth around the world has been surprisingly strong of late, despite higher interest rates. Some of the more positive recent inputs to the “barometer” include a sense of overall optimism among investors, reasonably positive readings on corporate investment, rising earnings forecasts, low and consistent levels of job creation, and some signs of improvement in manufacturing.
With readings still forecast to track above 50, the growth outlook appears to be favorable for now. We offer a range of forecasts from good to bad (the dashed lines), but the “base case” forecast (solid projected line) remains on a constructive path (above 50).
Nonetheless, it still makes sense to us to keep focused on quality. At some point, there will be surprises and challenges that will call for a more defensive approach. We want to make sure we own the types of solid companies that other investors will seek out whenever that time comes.