When economic growth starts to slow, investors prefer safer stocks to riskier ones. That’s one reason we’re seeing so-called high-quality stocks outperform in 2019, a year in which recession fears have run rampant at times.
That outperformance, however, comes at a price: High-quality stocks are now a lot more expensive than they used to be.
Vitali Kalesnik, head of research for Europe at Research Affiliates, notes that a strategy that buys stocks with highest profitability in the U.S. market—and sells those with lowest profitability—rose over 40% from the beginning of 2017 to September 2019. As a general rule, expensively traded stocks tend to revert to the average. That’s a fancy way of saying they’re likely to underperform.
Not everyone is that worried about valuations. Holly Framsted, head of U.S. factor ETFs at BlackRock, doesn’t think that quality stocks look expensive, at least as defined by the firm.
The iShares Edge MSCI USA Quality Factor exchange-traded fund (QUAL) has risen 26.8% this year, compared with the Russell 1000 index’s (.RUI) 24.3% gain. While the quality group is typically priced higher than the market, Framsted explains, that relative premium is currently in line with its average level over the past few years. Since July, the relative valuation has even come down a bit from its earlier peak—and that’s a positive sign for the group, she says.
The dash to quality has never really been about valuation. Rather, investors have been worried about an economic slowdown. Since quality companies generally hold up better during a downturn, their stocks have become very popular. Whether you like them depends on where you think we are in the economic cycle.
The typical economic downturn lasts an average of eight months, according to Bank of America Merrill Lynch’s U.S. Regime Indicator. According to the bank’s calculations, that’s where we are now.
If the market enters what the bank calls the “early cycle” recovery stage, then quality stocks could lag behind. “We have been proponents of quality for the year, but risks are building in this style, which may lead to underperformance if macro data inflects,” writes Savita Subramanian, an equity and quant strategist at BofA Merrill Lynch.
BlackRock’s Framsted, by contrast, doesn’t think economic conditions are going to change soon—and that would mean quality stocks continue to outperform, even if their valuations are elevated. “The economic regime is constructive, and the relative momentum on quality stocks is positive,” she says. “We think it’s very important to not just focus on valuation, because there are other things in play that affect factor performance in the market.”
There are many ways to define the quality factor. For some, it means conservative corporate governance—strong profitability, cautious investments, and more cash returned to shareholders. For others, it’s a healthy balance sheet, a sign that a company isn’t heavily reliant on debt. Earnings growth and stability are sometimes used to gauge quality, too.
The major index and ETF providers all use a different mix of metrics to find quality. The iShares Quality ETF, for example, tracks stocks with a high return on equity, stable earnings growth, and low financial leverage. Research Affiliates’ Kalesnik and Jason Hsu argue that some metrics used to measure the factor don’t actually lead to market outperformance.
In a paper published in March, the duo back-tested a pool of 35 quality metrics and found that stocks with high profitability, low levels of investment, and conservative accounting and equity-issuance practices have shown statistically significant outperformance across different markets. Other metrics, such as debt levels and earnings stability, don’t seem to make much of a difference.
Earnings-related metrics tend to be already priced in by the time investors can incorporate that information, says Kalesnik, since the data are released infrequently and analyst predictions are usually spot on.
A high level of debt doesn’t mean a company is low quality. “Debt buyers are very sophisticated, maybe more sophisticated than equity buyers. If they are willing to lend you money, that means you’ve got cash flow, you’ve got hard assets in place,” Hsu said earlier this year.
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