Do Quality Stocks Protect You From a Market Crash?

Stock investors are seeking the holy grail – companies that offer growth and protection from the downturn when it comes

Dan Kemp 2 February, 2018 | 9:41AM

Given the current stretched equity valuations, the temptation to seek sheltered growth is strong. One place that could offer this best of both worlds are quality stocks.

By following a strict methodology that favours companies with higher return-on-equity, stable earnings and a low debt profile, the idea is to seek opportunities that are likely to offer higher-quality attributes that provide upside potential and simultaneously buffer against a downturn.

We have found that so-called quality companies could be a desirable place to look and have investigated the quality landscape to see if the investment case stacks up.

While nuances manifest themselves in this space, we find that the long-term investment thesis for quality could well be worthy of investors’ attention, especially on a relative basis.

From the outset, we must highlight that an investing nirvana rarely exists. We all want to find fundamentally sound assets with high prospective returns and very low risk, but they are rarely so obvious. So, our ambition is far simpler.

We want to assess whether higher-quality companies are subjected to behavioural cyclicality like any other asset, and whether this can offer windows of opportunity to improve reward for risk at a portfolio level.

The Performance Differential has Mildly Favoured Quality Assets Since the 2008 Financial Crisis

When exploring this issue, we find the evidence supportive, although agreeing on a consistent framework is imperative. In this regard, Morningstar Investment Management have a clear preference to define quality as the certainty of future cash flows, which differs from some of the varying definitions in the industry.

For example, we would suggest that a high return-on-equity can be a robust measure of quality, although is not always the case as companies can appear highly profitable by having low equity book values, plus can be a synonym of high leverage. Therefore, getting to terms with the definition of quality is paramount, and cherry-picking definitions to suit a thesis must be resisted, known as the framing effect.

No Stocks are Immune from the Market Cycle

By looking at the world quality index under a rounded definition of quality, we find that these stocks are not immune to investment cyclicality, with quality stocks experiencing valuation changes across the cycle like many other traditional market-cap weighted assets.

This needs to be considered both absolutely, and relatively, as the ranking of assets should encompass a well-rounded view of the risk to reward landscape. Said simply, we want to understand what could happen, allowing for a wide margin of safety and over an extended timeframe, if valuations reverted to historical norms.

Of course, looking in the rear-vision mirror is easy, but it can expose some behavioural clues. For instance, we find that the stretching valuations among the world quality basket could be driven by a few key factors. First, one should be aware that the world quality index is heavily influenced by US equities generally, accounting for more than 70% of the index, which has garnered a lot of speculative interest.

Furthermore, technology stocks are the main sector overweight within the MSCI World Quality Index, accounting for 36% of the total exposure, which has also experienced a flurry of investor interest. Hence, it should not be a surprise that the quality index has done well in recent years given the tailwind from these two exposures.

Yet, when considered in a forward-looking context, this presents an interesting dilemma. Investors’ want to source high-quality investments for their defensive attributes, but simultaneously find that the biggest relative overweight positions; i.e., technology stocks, especially among US equities, could be grossly overvalued relative to longer-term averages. We also need to contemplate the idea of fundamental reversion.

The quality index favours companies with a high return-on-equity, but no attention is paid to whether these metrics may revert lower at a company level. This needs to be considered when we assess the prospective drawdown protection that a quality bias might offer, as it could differ significantly from historical patterns.

Are Quality Growth Stocks Expensive?

One way of sidestepping this problem, and one that we would advocate, is to look at the quality landscape from a country or regional level. This allows one to look through some of the concentration issues and focus on the more attractive areas of the market.

In doing so, we find that quality generally offers low prospective return profile across the board in absolute terms, low single digit returns in real terms, plus it could also be exposed to meaningful drawdowns given the stretched valuations. Nevertheless, quality stocks do appear considerably more attractive than market-cap weighted counterparts on a valuation-implied basis, highlighting possible pockets of opportunity.

This relative opportunity appears to be especially pronounced in the US, with the quality valuation-implied return exceeding the US market-weighted index by almost 2% per annum. Quality exposures in the European and emerging markets space also appear to offer attractive valuations relative to the market-weighted equivalent, although Japanese quality appears to be expensive in both absolute and relative terms. 

In summary, we find that quality stocks are subject to investment cyclicality like many other traditional asset classes, although can offer defensive characteristics and may help diversify against pro-cyclical positions. It is all about how you define it.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Dan Kemp

Dan Kemp  is Chief Investment Officer, Morningstar Investment Management EMEA

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