Some drivers want a car that lets them feel each sensation of driving—the acceleration, the curves, and even the bumps in the road. Others opt for a plush interior and forgiving suspension: They have places to go, but would rather get there in comfort. Investors may share some of the same tastes, and for those who are looking for a smoother ride, there may be good reasons to consider a strategy focused on “quality” stocks.
Quality stocks are usually defined by returns—how efficiently the company turns investments into profits. The hope for investors is that if a company’s business model and management team deliver profits consistently and efficiently, the market will reward them with smaller price swings and superior returns over time.
A strategy built around quality stocks may be of interest to the growing number of investors who are concerned not just with their long-term returns, but also with how many severe price swings they will have to endure along the way. An investment approach that focuses on higher-quality attempts to address these concerns by investing in companies that can capture much of the gains that stocks deliver, but with lower volatility compared with the overall stock market.
Quality offers a smoother ride
One simple way to judge quality is by the presence of a dividend. When management has the confidence to issue a dividend, it sends a signal that it believes in its ability to generate profits consistently. Since 1970, dividend-paying stocks have delivered returns that slightly outpace those stocks in the S&P 500® Index that haven’t paid a dividend. So the rewards have been similar, but on the risk side, things have looked markedly different: The volatility of non-dividend stocks (as measured by annualized standard deviation) has been roughly 50% greater (see chart right).
While a dividend may signal quality, it is just part of the story. Other quality measures include return on equity (ROE), which compares net profits to shareholder equity. The S&P 500® Index overall had one-year forward ROE of roughly 21% during Q1 of 2014, meaning that for each dollar of stockholder equity, the companies in the index were expected to deliver roughly 21 cents in profits. Higher-quality companies are generally those that have a forward ROE greater than the overall stock market. Some portfolio managers who have a quality approach also take into account return on invested capital (ROIC), which measures the relationship of after-tax net profits to invested capital, and free cash flow.
Stocks of higher quality have historically delivered attractive risk-adjusted performance, as many of these companies have well-known brands and competitive advantages that allow them to perform better during downturns. A Fidelity study, published last year, showed that low-quality stocks had significantly bigger price swings. In fact, the worst peak-to-trough loss on the low-quality stocks was 20 percentage points bigger than the worst loss on high-quality stocks (see the table right).
Quality as part of an overall strategy
When seeking better risk-adjusted performance, quality helps, but it shouldn't be considered in a vacuum. Ramona Persaud, manager of Fidelity® Dividend Growth Fund, says that one approach is to look for stocks that offer a combination of:
- Quality measured by various return (including ROE) or other metrics
- Attractive valuation relative to the industry
- Capital allocation, including dividends and share buybacks
Capital allocation plays a role in a variety of ways: A company could choose to reward shareholders with dividends or share buybacks, or it could invest the profits in acquisitions, or try to grow by hiring employees or building a new factory. The implications for investors are significant, as these decisions affect returns and future profitability.
“Over time, I believe investing in stocks that combine value with quality and good capital allocation can lead to better risk-adjusted performance,” says Persaud. But even those metrics aren't enough. For example, a CEO transition could lead to major changes in a company that a screen would miss, and there are times when changes in an industry make a stock riskier than some of the metrics listed above would suggest.
Greencore vs. Starbucks
Persaud points to Greencore Group plc as an example of a high-quality investment approach in action. Greencore provides freshly made foods to various consumer outlets in the United Kingdom, and now has contracts with Starbucks and convenience store chain 7-11 in the United States to do the same.
“Working with our research team, we first found this idea because Starbucks was expanding into food—which would provide another great leg of growth for the company, but the stock was priced at 20 to 25 times estimated earnings, so a lot had to go right to justify the valuation,” explains Persaud. “On the other hand, we thought that Greencore was positioned to benefit from the same growth and was trading closer to 13- to 14-times estimated earnings. At a below-market starting valuation but with similar growth drivers, a higher dividend yield, and improving returns and therefore quality profile, I felt the risk-adjusted estimated return for Greencore would be superior.”
Look for dividend growers
So where do you look for these stocks now? Increased investor interest in dividend-paying stocks has resulted in high prices for some traditional quality income names, particularly on higher-yielding stocks, as the chart below shows. At the same time, dividend payout ratios are low by historical standards, suggesting that companies have room to increase payouts over time. Persaud says this may argue for dividend-growth companies, rather than companies with high current yields.
Consider value tech
Persaud says she has found opportunities for dividend growth at quality companies in a sector not traditionally known for value and dividends: technology. For instance, Oracle (ORCL) and Microsoft (MSFT) have offered traits that she has found attractive relative to higher-flying tech companies. These two companies recently traded for 12–14 times estimated earnings while having reasonable volatility profiles, and better-than-market profitability levels. By contrast, some popular tech names have much worse profitability while sporting valuations of over 100 times 2015 estimated earnings, and volatility far worse than the market’s.
“High valuations are a sign of high expectations, so certain stocks can be seen as ‘priced for perfection,’” observes Persaud. “On the other hand, stocks like Oracle and Microsoft are valued as if their superior returns will fade quickly, and I have been willing to take the other side of that position.”
Investors who are looking for the returns of the market, but who may hope to avoid some of the bruises from bumps along the way, may want to consider the case for quality stocks, think about incorporating value and dividends into their strategy, and look in sectors not traditionally known for dividend growth.
Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.
Past performance is no guarantee of future results.
Diversification and asset allocation does not ensure a profit or guarantee against loss.
All indices are unmanaged, and performance of the indices includes reinvestment of dividends and interest income, unless otherwise noted. Indices are not illustrative of any particular investment and it is not possible to invest directly in an index.
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