Time to stock up on quality?

“Quality” stocks are said to offer a measure of portfolio stability ― a trait that becomes more valuable when markets are volatile and/or the business cycle is growing older. Both are true today. Tony DeSpirito offers his take on investing for quality.

It almost sounds intuitive that you’d want to own a quality stock. Why would you choose an inferior product in any scenario, particularly if cost were not a prohibitive factor?

I am a believer in and perennial practitioner of quality investing. It’s an enduring theme across our fundamental equity platform, given its relevance to both growth and value investors. It is of particular importance to the BlackRock Equity Dividend Fund, where we target strong businesses with the ability to grow dividends.

As the economic and business cycles age, we believe a focus on quality is increasingly important across the board as a means to enhance portfolio resilience. The market gyrations this month have offered another reminder of why quality matters.

A time for quality?

The VIX index, a common measure of stock market volatility, rose from a sedate average of 13 in July to nearly 20 in the first half of August. We find companies displaying quality characteristics such as strength in balance sheets and free cash flow are better able to weather such bouts.

While the current moment argues well for quality, I have found it to be a worthy proposition from a long-term risk/reward perspective regardless of the environment. Yes, there are times when it will work less well: Quality tends to under-perform in sharply rising markets, such as when the economy is coming out of a recession. At times like these, riskier lower-quality companies with higher leverage tend to outperform as they surge from their beaten-down state.

But a look at the chart below shows quality held an edge in the throes of the last recession (mid-2007 through early 2009), and also has outperformed during the bull market that followed.

Bottom line: Quality stocks may forfeit some incremental return in big market bounces, but history suggests they also are likely to lose less in the inevitable falls. This, on a net basis, makes them better investments over the course of a full cycle, we believe.

Quality stocks particularly stand out today. The fact that we are late cycle and markets are being rocked by U.S.-China trade noise and the vagaries of an election cycle tells me we may be in for a continued period of heightened volatility. A focus on quality stocks can allow investors to stay in the market to benefit from potential upturns, but with a measure of prudence built in to buffer downturns.

What are the markers of a quality stock?

In my experience, most investors can understand quality when they see it. And there’s the rub: by then it’s widely visible in the marketplace. It’s much harder to identify quality ahead of the broader market, to know what price to pay for it, and how to predict its durability. This is both a quantitative and qualitative exercise.

Quantitative measures tend to be backward-looking. A quality company should have a record of out-earning its cost of capital. We look at a company’s return on equity (ROE), balance sheet health and franchise strength.

We want a high ROE to be driven by high return on invested capital (ROIC)―not from debt. What can contribute to a high ROIC? A great collection of brands, a unique product or unassailable cost advantages. ROIC is a better indicator of quality in some sectors than others. In utilities, for example, fixed costs tend to be high and can limit value creation as measured by ROIC.

Even cyclical companies, whose fortunes tend to be tied to the economic cycle, can be worthy quality plays. The key is to judge the company over a full cycle, not a discrete point in time.

Qualitative insights are forward-looking and rely more heavily on judgment. Our job as fundamental investors is to look at the competitive landscape and ask questions such as: Is there a structural reason for a large gap between earnings and cost of capital? Is the company’s historical ROIC sustainable? Can it improve? Or is there potential disruption ahead that could deteriorate the ROIC? The goal: To understand how quality measures may change over time.

icon-pointer.svgSee Tony’s Q3 watch list.

Where can you find quality in today’s market? Two areas are scoring well on our quality screens: health care and technology. The latter is typically seen as more reliant on the economic cycle, yet the free cash flow, balance sheet strength and relative earnings outlook are flashing “quality” today.

My next blog post will dig into where to find quality, dispelling some myths about sector, size and price. I hope you’ll stay tuned.

Tony DeSpirito is Director of Investments for U.S. Fundamental Active Equity and a regular contributor to The Blog.

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