The Quality Proposition

With fears of overvaluation pervading stock markets, GAM Investments’ Julian Howard examines the long-term case for equities and the role of quality stocks as a feature in any strategic equity allocation.

21 September 2023

• Equity investors are torn between ‘buy and hold’ and poor fundamentals
• Intuitively, stable profitability commands a premium in stretched markets
• Quality stocks may improve equity ‘texture’ for investors through this period

In investments, often-competing philosophies and mantras abound, not least because this is not a scientific endeavour. For all the growth in professional qualifications and the now-enormous body of available academic literature, few have ‘cracked the code’ and delivered consistent outperformance year in, year out. In the absence of a single, accepted law of investing in which everyone would – impossibly – be a winner, investors are left to sift through centuries of past data and develop their own rules of the road.

Almost inevitably, different approaches end up contradicting each other and can even become contradictory in themselves. Taking no less than Warren Buffett as an example, the Sage of Omaha has clearly stated that trying to time markets makes fortune tellers look good, while also being on record as saying, “Be greedy when others are fearful”, itself advice on market timing. Perhaps for someone of Buffett’s track record and stature (he has probably come closest to cracking the code), such contradictions can be pulled off. As F. Scott Fitzgerald remarked, the test of a first-rate intelligence is the ability to hold two opposing ideas simultaneously.

Investors today also face a collision of investment ideas, specifically the very long-term case for equities versus overvaluation today. The weight of evidence shows that long term investing is the best way to generate superior returns. Whether it’s Jeremy Siegel’s constantly updated buy-and-hold bible ‘Stocks for the Long Run’ which gave birth to the investing world’s equivalent of Moore’s Law – the Siegel Constant – or the National Bureau of Economic Research’s (NBER) seminal 2017 paper ‘The Rate of Return on Everything, 1870-2015’, the message that stocks have a history of being the best investment over long horizons is the closest the investment community gets to a consensus.

However, most investors can’t help but keep a nervous eye on the short to medium term. Indeed, many have liabilities they may need to meet over these periods. And the ‘now’ is offering very little comfort. Over virtually every established metric, US stocks (accounting for 66% of the MSCI AC World Index) look expensive. The Shiller Cyclically Adjusted Price-Earnings (CAPE) ratio for example trades at over 30x, well above its long-term average. Relative valuation measures are also flashing red. The state of the equity earnings yield versus the risk-free yield from cash is especially concerning. Today, short term US Treasury bills closely tied to the prevailing Fed Funds interest rate are giving investors a better yield than equities.

Let that sink in for a moment. It effectively means that over the short term at least, there is just no case for stocks. For investors like John Hussman, these so-called ‘Iron Laws of Valuation’ are not to be ignored but should be acted on before it is too late. While markets have been in an extended ‘megarally’ since mid-October last year, there are indeed increasing signs of anxiety amid the extended valuation measures. This perhaps goes some way, along with renewed fears around rate rises, to explain the -4.5% air pocket the S&P 500 hit from the end of July to 24 August this year.

Chart 1: When doing nothing pays – T-Bills now yield more than stocks:

Past performance is not an indicator of future performance and current or future trends.

But with F. Scott Fitzgerald in mind, it is not intellectually inconsistent to keep holding equities. The long-term case remains intact given that the decades of stock market history that have led to powerful observations like the Mr. Siegel’s 7% real return for stocks already include periods of overvaluation. And while many inevitably led to corrections, the market recovered thereafter. A good example of these historic periods of overvaluation would be the technology boom of 2001 or the housing expansion in the run-up to the global financial crisis of 2008.

Furthermore, just because valuations and relative equity premiums over risk-free rates are uninspiring now, they could yet improve. For example, the Federal Reserve could start lowering interest rates in 2024 given that headline US inflation has now eased to 3.2% at the latest reading. Alternatively, US corporate earnings prospects could improve given the unexpected resilience of US consumers and therefore the broader economy. Robust house prices and retail sales growth of (also) 3.2% make a good case for this.

For many investors though, even these reassurances are not enough and some way of transcending short-term overvaluation and the volatility that tends to come with it is required at the portfolio level. In the multi-asset context, the obvious lever is asset allocation itself. But if the aforementioned poor fundamentals have already steered the equity allocation down to a more ‘neutral’ level in anticipation of worse future returns, the issue becomes whether an outright underweight is now appropriate. Given the structural long-term case for equities, an underweight to the market carries significant risks around when to eventually re-engage. Recession and falling markets offer the best opportunity for this but also feel the most counter-intuitive.

One way to avoid being forced into such a decision would be to seek to optimise the granularity of the equity sleeve without significantly changing the exposure to it. It is both possible and entirely legitimate to build a more intrinsically resilient equity portfolio without having to resort to risky asset allocation decisions which could compromise the benefits of staying permanently invested.

One of the most inherently appealing ways to do this is via so-called quality stocks, in our view. While precise definitions can vary according to provider, quality stocks usually exhibit a solid and consistent revenue stream and are typically firms with strong margins and low levels of debt. High quality firms therefore tend to have a high return on equity, a growing earnings profile and low leverage on their balance sheets. Intuitively, and in practice, such characteristics are desirable during periods of volatility and / or overvaluation. When markets are on shaky ground, solid fundamentals tend to command a premium.

The chart below demonstrates how quality stocks as measured by the MSCI USA Quality Index have outperformed the standard MSCI USA Index as US equity earnings yields have consistently fallen (amid higher prices) in the broader market. Quality stocks also offer style diversification. Emphasising Growth stocks with their exposure to tech themes like artificial intelligence (AI) is a sound way to transcend a world of economic stagnation but it has its ups and downs. A complementary, sector-neutral Quality allocation can help smooth this out over time. In this sense, we believe Quality is also a better diversifier than Value (essentially cheap stocks) because it tends to avoid fundamentally challenged business models in the first place.

Chart 2: Quality has been an effective answer to declining earnings yields:

Past performance is not an indicator of future performance and current or future trends.

Markets today are presenting an uncomfortable challenge to all but the most committed. It is no exaggeration to declare that fundamentals are sub-optimal right now but that the intrinsic case for stocks over time remains undimmed. Investors need to reconcile this stark contradiction without taking drastic and potentially risky action like outright underweighting equities and thus being ‘out of the market’ with all that entails. While no investment portfolio holding even a modest exposure to stocks is going to be free of volatility, careful style selection can optimise risk-reward within said exposure and make the short term that much easier to digest. Quality stocks have a role here and should be considered as a quasi-permanent feature of any strategic equity allocation. It may be going too far to assert that holding them satisfies F. Scott Fitzgerald’s intelligence test, but they do represent a pragmatic reconciliation of today’s investment conditions with the still-persuasive case for long term investing.