The Quality Conundrum Has Created Tremendous Opportunity
The market has a way of frustrating even the most patient investors. Value investors who correctly identified the expensive valuations of large cap equities in the late 1990s spent several years watching those overvalued markets become even more so. Investors who correctly identified the nominal lows in stock prices in 1974 had to wait another seven years for their investments to begin compounding at meaningful real rates of return. Investors who watched gold appreciate over 1,100% in less than ten years by November 1979 -to what must have surely seemed like a speculative price of over $400/oz- must have been shocked to see it double once more to over $850/oz over the course of the next few months. As the eminently quotable John Maynard Keynes noted, the market can stay irrational longer than most investors can stay solvent. This, no doubt, is a lesson learned and relearned throughout history.
Fortunately, for those investors who aim to stay solvent and generate a meaningful return along the way, the occasional irrationality of market prices has a counter force. This counter force- mean reversion- is driven by the closest thing we have to a law of gravity in finance- valuation. As James Montier points out (and countless academic studies have shown) in the Seven Immutable Laws of Investing , it is the primary determinant of long term returns.
Those focused on valuations were pleased to see stocks trading around 700 on the S&P 500 in March of 2009. At a normalized P/E of 13x the market was priced to deliver decent (call it 8-10% annualized) returns for the foreseeable future. Investors of nearly all types, and in nearly every risky asset class, saw tremendous value. Only those paralyzed by fear or a lack of liquid capital were unable to benefit from the cheapest market we had seen since the mid 1980s.
Click to enlarge images
Source: Sitka Pacific Capital Management
The joy of inexpensive markets faded rather quickly, however, with the S&P 500 rallying more than 40% over the subsequent 6 months and going on to appreciate by more than 75% by the end of 2010. In essence, the promise of 5-10 years of 8-10% annualized returns were compressed into just a handful of quarters. Skeptics have observed that there has been more than just fundamentals driving stock prices over the last few years. Whether it is crisis-induced fiscal and monetary policy, rampant global liquidity from expanding central bank balance sheets, or the shady side of "animal spirits"- something just didn't feel right about the nature of the stock market's rally from the March 2009 lows.
The Quality Conundrum and the Dash for Trash
During the market rout of late 2008 and early 2009, the market punished the stocks of the weakest companies the most. This made sense as we were not only in a recession which meant declining revenues, but many companies had taken on a tremendous amount of debt over the previous 5-10 years. As Russell Napier of CLSA reminded us at the CFA annual conference , "equities are the fine sliver of hope between assets and liabilities." The prospect for increased bankruptcy risk rightly drove prices of the stocks with the most financial and operating leverage down the most. High quality stocks were outperforming their lower quality brethren.
However, once it became clear that the Federal Reserve and the U.S. Government would be the lender of last resort, committed to a policy of 'extend and pretend' in order to minimize the near-term pain of failed businesses, the dash for trash was on.
In 2010, Brian Smith, CFA, of Atlanta Capital Management published The Third Dimension: An Investor's Guide to Understanding the Impact of "Quality" on Portfolio Performance . In the piece, he makes a compelling case for the presence of a long-term, risk-adjusted return advantage for high quality stocks which he defines as those rated B+ or better by Standard and Poor's.
Source: Atlanta Capital Management
Unfortunately, similar to the excess returns that can be found with value stocks, the relative returns can be choppy- there can be long periods when low quality stocks outperform. Witness the chart below which shows the rolling 12-month returns for high and low quality stocks (in excess of the Russell 3000 broad stock index) from 1980 to 2009. As noted above, during 2008, high quality stocks delivered over 4% excess returns vs. the Russell 3000 while investing in the lowest quality stocks resulted in an excess loss of over -2%.
source: Atlanta Capital Management
However, the outperformance of high quality stocks was short lived as 2009 saw the lowest quality stocks outperform the broad market by more than +15%, the largest margin in at least the last 30 years. But that doesn't even tell the whole story. Over the same period, the highest quality stocks underperformed the broad market by nearly -9%, also among the largest margins in over 30 years. By the end of 2009, the spread between the excess returns of the highest quality stocks and the lowest over the preceding 12 months, over -24%, was the most extreme it had been since the market peaked in early 2000.
The Law of Gravity At Work
The extreme divergence in the returns to high quality and low quality stocks left the relative valuations of the two groups out of whack. Normally, high quality stocks are awarded premium valuations relative to their low quality counterparts. This makes both intuitive and theoretical sense as high quality stocks tend to have higher returns on equity and more stable earnings. However as Brian Smith of Atlanta Capital showed, at the end of 2009 high quality stocks actually traded at a 15% discount to low quality stocks on current earnings and sported a dividend yield more than 60% higher.
2010 saw the anomalous performance moderate some, but investors focused on taking advantage of the mismatch continued to be frustrated as high quality stocks lost over -4% and low quality stocks gained more than +6% in excess of the broad market. The low quality nature of the market rally was particularly evident in the rally sparked by the second round of Quantitative Easing in the 4th quarter of 2010.
Source: Atlanta Capital Management; Sitka Pacific Capital Management
So far in 2011, we've seen a clarifying of the quality conundrum. Much in the same way the risk markets have broadly reassessed the sustainability of stimulus-driven returns, the outperformance of low quality stocks seems to have reversed course. This reversal has been confirmed by a commensurate positive excess return to high quality stocks. In the 12 months ending October 31st, high quality stocks have generated nearly +1% excess returns while low quality stocks have lost over -2%, for a spread return of over +3%. This trend is sure to have strengthened into November.
Agreeing to Agree. And Disagree.
It is difficult to say what exactly drives returns to high or low quality stocks over various time periods. Certainly valuation is important. At the peak in 2000, larger, high quality, "blue-chip" stocks carried excessive premium valuations- just as the "Nifty Fifty" did in the late 1960s. The laws of valuation ensured poor subsequent returns. What we label or call quality is also subject to error- many large capitalization investment and commercial banks, insurance companies, and the like have all been inappropriately highly rated by S&P recently. However, we can also measure quality in different ways. An analysis of factor returns, for example, shows that stocks which rank highly on certain quality factors like earnings stability, inventory turnover, debt/assets, ROE and the like have generated meaningful long-term excess returns, though in varying amounts for different sectors.
Furthermore, it is difficult to generalize about the propensity for high or low quality stocks to outperform in up or down market environments, which gives market bulls and bears something to agree on. During the secular bull market of the 1980s and 1990s, high quality outperformance was the norm, with low quality surges only appearing briefly and typically in speculative periods preceding the short corrections of the era. In contrast, during the secular bear market of the last twelve years or so, high quality stocks seem to only have delivered excess returns during market declines. Perhaps the sustainable and ongoing outperformance of high quality stocks is a necessary marker of durable broad market gains. The question begs further research.
This gives the long high quality/ short low quality trade a potentially unusual and extraordinarily valuable distinction: it can generate meaningful returns whether one expects a cyclical broad market decline or whether one expects that we are in the early stages of a multi-year bull market. As long as relative valuations for high quality stocks remain attractive, the relative returns can be robust. Indeed, in GMO's monthly forecast of 7-year asset class returns, U.S. High Quality stocks are priced to deliver +5.4% annualized real returns which far exceeds the +1.8% forecast for the U.S. Large Cap space and -0.4% forecast for the U.S. Small Cap class.
The way we see it, we are likely embarking on an era where high quality stocks will significantly outperform low quality stocks as we work our way through what will be the third, and perhaps final, painful market decline of the secular bear market and continue that outperformance as the seedlings of the new secular bull market which will eventually drive the broad market indexes higher in subsequent years. The attractive absolute valuations of many high quality companies which trade at single digit P/E and cash flow multiples, around tangible book value, and with respectable 3-6% dividend yields will be the foundation for those eventual gains.
Source: Atlanta Capital Management; Sitka Pacific Capital Management
At Sitka Pacific, we are favoring global high quality stocks with inexpensive valuations in the equity portion of our Absolute Return strategy while hedging that exposure with positions which move against various broad market indexes. In our long/short equity strategy, Hedged Growth, we are additionally able to take advantage of expensive, low quality quality stocks on the short side- leading to a more direct manifestation of this theme- and an opportunity to generate meaningful returns in a variety of market environments.
Bringing It All Home
Understanding the returns to high vs. low quality stocks is as important today as understanding growth vs. value. Whether you are picking stocks or evaluating outside managers, it is essential to understand what the drivers of future returns are likely to be. The quality conundrum has created tremendous opportunity and some investors will do better than others in capturing these returns. We believe a flexible long/short approach to emphasizing high quality stocks with low valuations will generate meaningful positive returns in a world where they will continue to be hard to come by.
See also EXG Is Failing To Generate The Income It Seeks on seekingalpha.com