An independent professional's take on the latest news and trends in global financial markets

Why quality stocks pay off

It is no accident that some of the best performing fund managers of the last few years have been those who have stuck to investing in powerful global equities with a consistent history of profitability and sustainable earnings and dividends. In the UK those who fall into this camp include Neil Woodford at Invesco Pereptual, Nick Train of Lindsell Train, Sebastian Lyon at Troy Asset Management (mentioned in my last post) and Terry Smith, whose equity funds solely buy and hold this kind of high return on equity stock. It is also of course at the root of Warren Buffett’s long success as an equity investor.

But why do so-called quality equities (defined as stocks which have low leverage, high returns on equity and consistent earnings) perform so well, yet are so regularly overlooked by the majority of investors in favour of more speculative growth stories? A recent research note from Jeremy Grantham’s team at GMO uses long run US data to highlight the persistently superior performance of quality stocks and their particular attractions in today’s binary (“risk on, risk off”) market conditions. The primary driver behind this superior performance is the ability of these companies to preserve and grow capital, not to lose or squander it as many do, either through incompetence or normal competitive pressures.

Here are a couple of short extracts from the GMO research paper:

True competitive equilibrium is a rarity in the global economy. Instead, we find persistent winners and persistent losers. The competitive paradigm says that highly profitable activities attract capital, and that capital flees those with low profits. This is the market mechanism behind mean reversion, which is supposed to close the profitability gap. In reality, certain companies earn persistently high returns on equity. Superior returns are delivered to investors in the form of dividends, stock buybacks, and accretive growth.

At the same time, unconstrained abusers of capital squander equity at the expense of investors through dilution, non-accretive growth, and bankruptcy. Take a look at the current state of our global financial industry for a textbook example of capital abuse. Banks robbed the investors twice. First, in their reckless pursuit of loan growth leading up to the financial crisis, and then again, when they printed shares in order to survive. Their behavior is a little like that of a mugger who, having nicked you once, drags you to the ATM in order to mug you again. This is ignored by the market to an astonishing degree. The market persistently underprices quality companies while repeatedly giving capital injections to money-losing enterprises, which survive to destroy capital in the future.

Yet investors in practice steer the other way from this rewarding direction most of the time:

Put simply, profitability is the ultimate source of investment returns. Contrary to popular belief, profitability can be forecasted and superior profitability persists. Investors systematically undervalue the unexciting stability of quality stocks (except during times of financial crisis). Rather than being beholden to some black box model of low volatility, or held hostage to some arbitrary optimizer, we prefer to focus on real economic risk. We would argue that a fundamental focus on profitability remains the best way to minimize the true risk with which investors should be concerned.

Despite the benefits of this approach to low-risk investing, it appears that not many have the will power to stay true to the concept. Stability is simply not exciting enough for most investors. Many investment managers find it hard to resist the temptations of minimizing tracking error, following the herd, or going for a little excitement offered by “story stocks” (those false pretenders to true growth). End investors – who really should be focused on real returns – want absolute returns in bear markets, but tend to seek relative performance in bull markets, an example of what J.K. Galbraith described as the “extreme brevity of financial memory.” All of these factors act as distractions, forcing the focus from the fundamentals.

Added to that is the ever-increasing difficulty of distilling true economic profitability from reported numbers. The complexity of modern-day accounting combined with the lack of demand for long-term economic precision has allowed corporations to report numbers that have a very weak link to reality. History has shown that when there is a disconnect between accounting and true economics, the result will always (eventually) land in favor of economics. Yet, the difference is obscured until the investment tide goes out, at which point it is too late.

Of course growth stocks will have their day in the sun again. Investment styles come and go. Quality stocks have proved an effective safe haven – much safer in reality than government bonds with minimal yields – for some time now. That won’t persist indefinitely. Investor hunger for quick returns is insatiable, and with so much money having flown into bonds recently, the liquidity surge that could follow any signs of permanent  improvement in global prospects (such as a convincing Eurozone settlement) would probably pour first  into low quality, high beta stocks, just as happened in 2009.

But the point about quality stocks, although some have begun to look quite pricey, is that while they tend to be persistently undervalued by the markets, they retain the attractive characteristics of (a) outperforming in relative terms during times of market panic: and (b) still producing strong absolute returns in good times. For prudent long term investors, these are just the characteristics you should find suitable to your temperament. You can download the full GMO report here. The charts on profitability pesistence are particularly powerful.

CMSAttachmentDownload.aspx (application/pdf Object).

Written by Jonathan Davis

August 18, 2012 at 12:17 PM