“Quality stocks” give false comfort

Quality is a word investment managers love.  How often do we hear a period of underperformance explained as “quality stocks were out of favour”. Or, “the managers will focus on quality stocks to recover performance”.  Clients seem reassured by the notion that it is somehow the market’s fault for failing to recognise real value and low risk.  The term reveals a lot about investor psychology, but does it have any meaning in the real investment world?

 Quality has a reassuring ring, and it is easy to see why it is overused in investment. Typically, investors mean mega-cap stocks that are less cyclical.  Pharmaceuticals, telecoms and food and drink usually feature.  Certainly these sectors may be less economically-sensitive, but whether the businesses deserve a growth label is open to question.  Some major pharmaceuticals, for example, are experts in creating a smooth progression of earnings per share helped by continual restructuring charges, flattering a dull sales trend.   Investment managers use the word with little distinction between value and growth.  The superior stockmarket size of quality stocks is meant to be endorsement enough.

 The description typically means that managers believe the stocks are less risky.  But, expecting outperformance with less risk represents unrealistic investor behaviour.  While lower beta stocks can outperform over the longer term, shorter term returns usually involve accepting more risk.  It may be that the risks in quality stocks are misunderstood, or there is a built in over-valuation driven by this investor love affair.  Quality seems reassuring, but outperformance rarely comes when comfort is the main focus.  Even worse, there can be a false comfort from the halo effect of presumed quality.  As BP has shown this year, even the largest and highest yielding stocks can carry risks that are far from obvious and certainly not reflected in historic betas.

 Owning the most liquid stocks can reflect closet indexing, or the problem that large funds have in buying mid or small cap.  The investment strategy may be driven as much by inertia, or the difficulty for big funds in gaining meaningful exposure to faster growing or more interesting parts of the stockmarket.   And, it can even represent a lack of conviction, when managers prize mega-cap stocks for their ability to be easily sold in a downturn.  That sounds more like trading beta or calling market direction, than true long term growth investing.

 Surprisingly, in recent months, so-called quality stocks have actually started outperforming.  It may reflect a flight to safety, or even a new focus on dividend yield.  But, mega-cap stocks in low growth sectors have begun to pick up.  Most of these stocks did not join in the June rally, but have recovered since.  Indeed, for stocks like Glaxo and AstraZeneca, the turning point can be traced back to April.  In the past, these periods of outperformance by mega-cap stocks have stopped as abruptly as they began.  The long term pattern is not encouraging.  But, for now at least, quality need not be used by fund managers as an excuse. 

 However, the label itself is unhelpful and has no place in investment analysis.  It can mislead clients and even investment managers themselves, as to the true nature of risks.  It may be that quality is returning to favour, but fund managers should look past the false comfort of market capitalisation and halo effects.

This article is for informational purposes only. The opinions in this article are the author’s own. The information presented in this article has been obtained from sources believed by the author to be reliable, however, he makes no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Colin McLean may have an investment in any of the companies mentioned in this article.

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