The run up in equity markets this year has made many investors wary going into Q4. They now have to weigh heightened valuations – particularly in the US – against the effects of higher interest rates, sticky inflation and slower economic growth.
A traditional way to deal with tough conditions has been to align portfolios towards quality stocks. These typically have high levels of profitability, a robust balance sheet, strong cashflow conversion, low earnings volatility, and healthy dividend cover. The attractions are obvious: in a harsh economic environment, recurring cashflows and low leverage should make companies more resilient. Crucially, a quality company’s ‘moat’ – the ability to maintain a competitive advantage against rivals – should protect its position while also allowing it to pass on inflationary pressures to consumers.
However desirable these characteristics, investors point out that it’s vital not to overpay, and to consider the overall environment and valuation picture. Rory McPherson, CIO at discretionary fund managers MFDM, said the firm’s portfolios have a skew towards quality, but at the right price. ‘In this environment, we think quality is the right thing to own and think investors will be focused on the certainty of cash today, rather than the hope of growth tomorrow,’ he said. This is partly because the risk-free rate has risen so dramatically. With returns on cash deposits so much higher, companies are not being rewarded as they were for their long-term potential, he said.
But given their historic low variability in earnings, many companies that screen well for traditional measures of ‘quality’ have now been bid up to high valuations, he adds. ‘That’s an issue for us because we are looking for quality companies with good visibility of cashflow that also give a margin of safety in terms of price. So we have a strong discipline around companies that pay dividends – because only high quality companies can grow their dividends consistently in this environment – but we also look for value in pricing,’ he said. ‘This means we look for companies that might not necessarily screen as quality via obvious metrics,’ he adds.
Promising hunting grounds
At a sector level, he points to regulated utilities and healthcare as areas where managers can find companies with strong earnings resilience and pricing power that are trading on relatively attractive valuations.
Emerging markets are one place where these opportunities can be found. McPherson cites the EM specialist Pacific North of South fund, run by Matthew Linsey and Kamil Dimmich, which focuses on companies that are growing their dividends over and above the risk-free rate. In August 2023 the fund’s holdings included Taiwan Semiconductor, Alibaba Group, Samsung Electronics and Emaar Properties. ‘The managers have a real discipline around holding quality value names,’ McPherson said.
He also cites Guinness Global Equity Income, run by Ian Mortimer and Matthew Page, which focuses on companies that have a return on capital greater than 10% in each of the previous 10 years.
Quality on the back foot
Paul Green, investment manager in the multi-manager team at Columbia Threadneedle Investments agrees that quality companies typically demand a higher valuation and points to the way that this became a problem when quality names de-rated during the 2022 selloff.
The backdrop was that during the low interest rate environment of the decade after the global financial crisis, share prices of quality companies performed well and valuations became elevated relative to historical levels, he said.
But as the cost of capital rose sharply throughout 2022, companies that were trading on high multiples de-rated. This was felt most harshly in high growth companies but it also impacted quality names. ‘Typically, you’d expect quality companies to perform well during a tough market environment given the more defensive nature of the businesses, but the price you pay for an investment ultimately determines the return you receive over time – this is a factor that can often get overlooked in times of excess, as it was during the technology bubble of the late 90s and during the period immediately after the Covid pandemic, ‘ Green said.
He added that other segments of the stock universe, such as cyclicals, might be more resilient than many would expect.
‘Companies on cheaper valuations are typically deemed to have more risks associated with them, whether that is cyclicality of the earnings, weaker balance sheets or business restructuring. But compared to the period after the global financial crisis, many ‘value’ companies have much stronger balance sheets and dividend cover, providing some downside protection to the investment case,’ he said.
Given that the valuation spread between cyclical companies and defensives is as wide as it has been for 50 years on some measures, a lot of bad news may already in the price for cyclical companies, he added.
