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
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.
- Read the full paper, “The Intersection of High Quality and Cheap Valuation.”
- Research Fidelity® Value Discovery Fund (FVDKX).
- Find stocks, ETFs, and mutual funds.