by Brad M. Weafer, CFA Chief Investment Officer
Executive Summary
- High quality stocks have underperformed low quality stocks to an extreme degree following the worst of the coronavirus-induced recession and bear market of 2020.
- Despite normal rotations out of high quality following past recessions, high quality stocks have outperformed low quality stocks materially over-time and are trading at compelling valuations today.
BFM follows a disciplined approach to equity investing. To summarize our investment philosophy; we seek to own exceptional companies that are highly profitable, have durable, stable, attractive business models, with bright, long-term opportunities for growth. These “high quality” companies, as we define them, have high and stable returns on capital, low financial leverage, and durable competitive positions. We attempt to purchase these companies at attractive valuations relative to their prospects. Portfolios of companies with these characteristics have historically achieved outsized returns over their “low quality” peers and standard benchmarks, while also experiencing lower volatility/risk (see Exhibit 1 below).
Simplifying this, we buy excellent companies when they are not expensive, resulting in long-term outperformance with lower risk. This seems pretty straightforward. The experience of BFM’s primary domestic equity strategies, High Quality Dividend Appreciation and High Quality Mid Cap, support this theory. More importantly, both strategies have experienced downside capture ratios of approximately 75%. This means in periods where the index declines, BFM equity performance falls only three-quarters of the index decline. How portfolios weather downturns have a critical impact on long-term returns. Steep portfolio declines necessitate even bigger returns to get back to even. Consider the math. A loss of 30% requires a much higher percentage gain (43%) to reach pre-decline levels. Downside risk management provides a psychological benefit too. Strategies that help reduce the risk of investors selling out of fear when the market is down can significantly impact wealth compounding.
This begs the obvious question, what’s the catch? Like any disciplined strategy, there are inevitable periods of underperformance that investors need to manage through to get the benefit of this long-term approach. This often occurs following recessions, when lower quality companies rebound after seeing results punished more so than high quality counterparts. The periods going into and out of economic extremes experience the most vivid outperformance and underperformance. High quality companies often significantly outperform at the advent of a recession (like we saw in February and March of last year) and lag the markets as economic prospects begin to improve like we are currently experiencing today. This was no more evident than in February when low quality was one of the best performing equity factors globally (source: Societe Genrale). According to research from Sanford Bernstein, high quality stocks have underperformed low quality by 15% year to date (through March 9). As you can see from Exhibit 2 below, this current rotation from high to low quality is as extreme as any time in the last 30 years, with the only close comparison coming out of the depths of the financial crisis. According to Bernstein, the rotation from high quality to low quality lasted 14 months, with low quality outperforming by 41% during that time. The stock market bottomed a full 12 months ago on March 23, 2020, suggesting we are closer to the end than the beginning of this regime change.
There are signs, though, of better relative return prospects ahead. Bernstein estimates that high quality stocks are selling at half the multiple of cash flow of low quality stocks. A 33 year low! A similar discount is apparent when looking at price to earnings ratios (see Exhibit 3 below). We note similar dynamics within our own portfolio companies. Quality is on sale! These opportunities have historically been a precedent for better returns ahead.
We often talk about being long-term investors and benefit from having clients with a like-minded philosophy. Despite being in the throes of a historic rotation away from our favored style, we are as confident as ever in our companies’ long-term outlook. We are also confident that few can see around corners to the next big risk for stocks. Our portfolio companies have proven to be adept at managing through unforeseen risks, like the global pandemic, and we expect them to manage well through a full cycle and beyond.
The team at Boston Financial Management is always available to answer your questions. Please do not hesitate to contact your Wealth Manager directly, or call our main line at 617-338-8108.