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Quality and value: recipe to outperform?

How to find stocks that may deliver above-average returns with below-average volatility.

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In study after study, one factor has been shown to indicate the potential for future outperformance of stocks: valuation. Over time, cheap stocks have tended to deliver better returns than expensive ones—a simple but powerful idea. But what if you could take that potential and enhance it, lowering volatility and possibly increasing returns?

A new study by Fidelity® Value Discovery Fund (FVDFX) manager Sean Gavin, Institutional Portfolio Manager Naveed Rahman, and Quantitative Analyst Salim Hart, indicates that adding a quality metric to a traditional value-based approach to stock picking may have the potential to help improve long-term results, both in terms of risk and return.

“Valuation has proven to be the most important individual factor for performance, and many investors know about the defensive nature of high-quality stocks,” says Gavin. “But our research suggests that the intersection of quality and value brings out all the positives of quality investing—meaning less downside and lower levels of volatility—and the enhanced returns of the value factor. So, in our study you got higher returns than pure value investing, with much lower downside risk. “

The case for quality and value

During the past 25 years, the 10% of stocks with the lowest valuation have delivered 400 basis points of average annual outperformance relative to the broad market (see the chart “Quality and value outperformed,” below).

“While growth stocks get more attention, the low expectations for value stocks mean that when they produce positive surprises, they have the potential to outperform,” says Gavin.

Quality investing—a preference for superior business models that consistently generate profits that are higher than a company’s cost of capital—can also be an important factor, both for returns and for volatility.1 The study looked at the long-term performance track record of high-quality and low-quality stocks from various start dates to a single fixed end date. For this study we defined high quality as the 10% of stocks in the Russell 1000® Index with the highest ROA (see the callout "Measuring quality" for a definition) and low quality as the lowest 10% of stocks measured by ROA. In the chart below you can see that higher-quality stocks outperformed roughly 75% of the periods in the study. The shaded periods above the horizontal line show the start dates when higher-quality stocks outperformed; the shaded bars below the line show the start dates when lower-quality stocks outperformed (though the magnitude of outperformance is not shown).

Why does quality help? For one thing, quality can contribute to the long-term compounding of capital: Because high-quality companies by definition tend to produce more return on their investments, they have more money to reinvest in their business. This can lead to a virtuous cycle of growth and profitability. In addition, many companies with high-quality metrics have strong underlying competitive advantages that persist over time, including brand recognition and intellectual capital. These competitive moats can translate into less volatile earnings margins and revenue growth.

Putting quality and value together

Measuring quality

There is no one perfect measure of quality. The study used return on assets (ROA), which is the percentage amount calculated by dividing net income into total assets, which shows how profitable a company’s assets are in generating revenue. This is the best single quality measure across all sectors, according to Gavin. However, in his own investment process he tends to use return on invested capital (ROIC), and in other areas, for instance financials, he may use return on equity (ROE) and ROA. Finally, Gavin applies more qualitative data about management and competitive positioning in his investment process.

While the lower volatility of quality stocks may be intuitive, and the case for value investing long established, the power of combining the two features may be less well known. Part of what makes the combination compelling is that there is not massive overlap. “A lot of cheap stocks are not high quality, and vice versa,” notes Rahman. According to the study, a portfolio that is equally weighted quality and value factors delivered better risk-adjusted returns and absolute performance than the broad market, or than using either factor alone (see the chart below).

“Over a longer time horizon, you can see the potential for a strategy that combines value and quality,” observes Gavin. “It’s a simple approach, but sometimes a simple approach is the best one.”

Value and quality in today’s market

According to Gavin, one of the advantages of this strategy is that it tends to outperform over most intermediate and long-term time periods.

“There are parts of the market cycle when lower quality and growth stocks are going to outperform, but it has proven extremely difficult for investors to accurately predict those changes in market conditions. But if you look back over the long term, a quality and value approach has offered the best probability of outperformance of all the different strategies,” he says.

One example of a company that has demonstrated these traits is Amgen, according to Gavin. While value investors may not normally buy up biotech stocks, he says Amgen has become so large and well developed, it has functioned more like a mature pharmaceutical company. “When it comes to companies that have patentable portfolios, Amgen has a big moat, has been continually growing, and recently the stock has been trading at prices I consider cheap. It has had incredible returns on investment, whether you’re looking at ROA or ROIC, and has a defendable franchise.”

There are other sectors in which Gavin has been finding opportunities. “If you rank the sectors in terms of quality metrics, whether you measure using ROE or ROIC, the top three are consumer staples, health care, and technology. Two of those three are very attractively priced right now—staples, unfortunately, are not.”

One company Gavin has found interesting in the technology space is Fiserv—a company that provides software and technology services to the banking industry. “Fiserv is another high-return company that has remained cheap, relative to its quality,” he says. “It has continued to grow, taken the high returns that it has earned and reinvested them back into the company, and if it didn’t have good opportunities, gave profits back to shareholders.”

The bottom line

For investors who aren’t trying to time the market cycle, the Fidelity research suggests that a strategy that combines value-based approach and a quality metric has the potential to deliver better risk- adjusted returns than either metric alone—or the broad market.

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Before investing, consider the investment objectives, risks, charges, and expenses of the fund or annuity and its investment options. Call or write to Fidelity or visit Fidelity.com for a free prospectus or, if available for the options, a prospectus or summary prospectus containing this information. Read it carefully.
Information provided herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any security. Discussion of individual securities is not intended to represent holdings of any Fidelity fund or investment product.
Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.
Methodology
Unless otherwise indicated, the following methodology was used for the quantitative analysis:
Universe Russell 1000 Index
Data sources FactSet for security prices and returns, Thomson Reuters IBES for EPS estimates to calculate P/E, S&P Capital IQ/Compustat for financial statement data to calculate ROA, and Russell Investments for index constituents. Performance data sourced from and calculated by FactSet’s AT3 backtesting application.
Factor definitions
P/E = Stock price divided by IBES next 12-month mean earn¬ings per share estimate. ROA = Trailing 12-month operating income divided by average assets excluding cash. Combination factors group each factor into percentiles, and then multiply these percentiles by the weights on the factors.
Hypothetical portfolio construction methodology All portfolios and benchmarks are equal weighted for the purpose of calculating returns. Unless otherwise noted, stocks are grouped equally into 10 deciles, and only results from the top and bottom deciles are used in this analysis. All deciles are sector neutral, meaning that stocks are ranked within Global Industry Classification Standard (GICS®) sectors for each factor. As a result, the sector weights within each decile are similar to the sector weights of the benchmark. All portfolios and benchmarks are rebalanced monthly, and monthly buy-and-hold returns are used in all calculations. Returns include reinvestment of capital gains and dividends, if any, but do not reflect any fees or expenses. To reduce the effect of outliers and data errors, monthly returns are capped at the 2nd and 99th percentiles— i.e., the top (and bottom) 1% of each month’s returns are set to the largest (and smallest) returns of the remaining 98%.
Techniques to overcome look-ahead and survivorship biases
Historical Russell 1000 constituents are retrieved at the beginning of each month and thus include nonsurviving companies that no longer exist today. All Compustat financial data are lagged by 45 days to allow for the normal procedure of reporting results with some delay after quarter end—e.g., financial statements for the March 31, 2010, period are not used in this analysis until the May 31, 2010, period.
ROA, or return on assets, is the percentage amount calculated by dividing net income into total assets, which shows how profitable a company’s assets are in generating revenue.
ROIC, or return on invested capital, is the percentage amount earned on a company’s total capital, calculated by dividing total capital into earnings before interest, taxes, or dividends are paid. ROE, or return on equity, is net income before extraordinary items available to common shareholders, divided by average common shareholders’ equity.
The Russell 1000® Index measures the performance of the large-cap segment of the U.S. equity universe. It includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership, and represents approximately 92% of the U.S. equity market. The Russell 1000 Index is constructed to provide a comprehensive and unbiased barometer for the large-cap segment and is completely re¬constituted annually to ensure that new and growing equities are reflected.
Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, economic, or other developments. These risks may be magnified in foreign markets. Value and growth stocks can perform differently from other types of stocks.
Growth stocks can be more volatile. Value stocks can continue to be undervalued by the market for long periods of time. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.
As of the most recent portfolio holdings published on August 30, the Fidelity Value Discovery Fund had 2.257% of assets invested in Amgen, Inc., and 1.138% of assets invested in Fiserv, Inc.
Past performance is no guarantee of future results.
Diversification does not ensure a profit or guarantee against loss.
All indexes are unmanaged. You cannot invest directly in an index.
Votes are submitted voluntarily by individuals and reflect their own opinion of the article's helpfulness. A percentage value for helpfulness will display once a sufficient number of votes have been submitted.
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