Buying higher-value companies pays
In the equity market rally that has followed the financial crisis, investors have been rewarded for owning stocks at the lower end of the quality spectrum
In the equity market rally that has followed the financial crisis, investors have been rewarded for owning stocks at the lower end of the quality spectrum. Although companies with weaker balance sheets, higher debt levels and other lower quality metrics were punished most severely in the crisis, the survivors had more room to bounce in the recovery.
Companies in the lowest tranches of the Standard & Poor’s Equity Quality Ratings (those rated C and below), for example, had returns slightly more than double those of the highest-rated companies (those rated A+) in the 12 months following the market bottom that marked the end of the crisis in March 2009. Lower-rated companies also were selling at a significant valuation premium to their higher-quality counterparts as a result of the rebound.
Recent market conditions notwithstanding, however, higher-quality companies have tended to produce stronger returns over the long run.
Quality companies can be described as ones that have sustainable, durable business franchises, strong balance sheets, strong free-cash-flow generation and managements that are good stewards of shareholder capital.
These companies also tend to possess enduring competitive advantages, such as high barriers to entry, superior business models, strong brands and pricing power. There typically is a history of steady operational performance, and lower volatility in earnings and cash flow growth through cycles. These features generally indicate a lower risk of shortfall and a higher probability that these companies can sustain returns over the long term.
From an operating perspective, these characteristics clearly benefited high-quality companies during the financial crisis. Over the long term, the characteristics also provide a sustainable advantage to investors.
Our analysis shows that owning inexpensively valued, high-quality companies provides that edge.
VALUE OF QUALITY
In fact, irrespective of valuation, there is a modest benefit from owning the highest-quality companies. For the purpose of this analysis, we segmented the universe into quality quintiles based on a company’s three-year average return on equity, volatility of the three-year ROE, and three-year average assets to equity as a measure of financial leverage.
Looking at a universe of the 1,000 largest U.S. companies by market capitalization, the analysis showed investors who owned the highest-quality companies from 1975 through 2010 would have experienced a cumulative excess return — versus a broad universe of U.S. securities — of nearly 11.5 percentage points or about 35 basis points per year.
Much more pronounced was the excess return that would have been earned by investors who owned only the cheapest stocks in the universe as measured by price-earnings ratio, regardless of their quality, over the same period. This cumulative excess return came to 360 percentage points, or 4.9 percentage points a year, clearly demonstrating that valuation is an important driver of long-term stock price performance.
The most dramatic relative-performance advantage, however, would have occurred at the intersection of these two variables of high quality and low valuation. Investors who owned the highest quality and most cheaply valued companies would have experienced cumulative excess returns of nearly 560 percentage points over that time frame, or 6.1 percentage points a year. The consistency of the relative outperformance of this group over rolling five- and 10-year periods is impressive.
Moreover, when we examined a similar universe of non-U.S. stocks going back to 1989, we found that the relationship observed in U.S. stocks is consistent globally.
The fundamental lesson taken away by our investment team is that companies with high levels of return on invested capital were more likely to sustain this positive attribute over time. Therefore, it is better to focus our efforts on identifying and owning shares in those companies rather than trying to identify the rare “home run” that results from finding a company that moves from third-rate to first-rate. Those companies that do emerge do not compensate for the high proportion of those that do not.
In general, many investors tend to be short-term-focused and underestimate the impact of compounding above-average returns over time. We found that quality companies selling at reasonable valuations can yield strong long-term returns for investors.
Katrina Mead is an institutional equity portfolio manager at MFS Investment Management.
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