By: Tim Hoyle, CFA, Chief Investment Officer
Levi Strauss & Co. was spot on with their 1980’s ad campaign “Quality Never Goes Out of Style.” Unfortunately, when it comes to stock prices, sometimes Quality does underperform.
Jason Zweig’s recent WSJ article, When Bad Things Happen to Good Stocks[1] , accurately highlighted the current struggles of many quality-oriented ETFs. Zweig, a superb author and journalist, made several good points:
- Investors in funds with quality in their name expect to lose less money in bad markets.
- Quality stocks tend to trade at above market multiples, but quality at any price is problematic.
- Quality is probably one of the most vaguely defined variables used to measure stocks.
If Jason had called on Haverford Trust, the home of Quality Investing, to comment on his article, we would have added a few distinguishing points to the basic tenets of his piece.
- Quality’s definition varies by investor, but Haverford’s basic definition of quality has not changed over our 40+ years in business. By our definition, quality companies demonstrate a proven track record through multiple economic cycles of generating consistent, predictable, and sustainable earnings growth. They conservatively manage their balance sheets, generate strong cash flows, and are committed to returning a portion of that cash to investors in the form of dividends.
- Quality stocks do tend to trade at multiples higher than the overall market, because they are perceived as better companies. Sometimes investors can get carried away assigning absurdly high multiples to these businesses. We believe above-market multiples are warranted for these stocks. As long-term investors, we would almost always rather pay a fair price for a great company than a great price for a fair company.
- By including dividends as a quality characteristic and being mindful of price paid, Haverford believes we can improve on the risk-reward ratio of many of the funds exampled in the article.
The single largest driver of a stock’s under-performance this year has been multiple compression, i.e. falling price-to-earnings ratios. High inflation and rising rates put a lid on the multiple investors are willing to pay for future earnings. The further out in the future and the higher the multiple, the greater the haircut. We have seen it in our own portfolio, the highest multiple stocks have been hit the hardest. Thankfully and by design, Haverford’s quality process incorporates a dividend focus. Dividends are the opposite of future earnings. Dividends are tangible and present today. So far this year, dividend paying quality stocks (the higher the yield, the better) have held up better than quality stocks that don’t pay dividends.
We are obviously in a bear market, with stocks down more than 20% from their January highs. However, whether we are in recession is not as obvious, especially as the definition is changing. Much of this bear market has been driven by rate fears, not fear of a weakening economy; higher interest rates make future earnings less valuable leading to multiple compression, while economic weakness is more likely to adversely affect lower-quality companies. Thus, this environment has proven a difficult one for the relative performance of many quality stocks. But we believe the nature of this environment may soon be transitioning. We believe we are much closer to the end of this rate hiking cycle than to the beginning. Stay tuned for an upcoming Havercast on this subject. Additionally, the probability of a recession and earnings hit is high given the Fed’s stance, and we have another Havercast coming out on that topic soon.
We expect that as the raising rate cycle negatively affects the economic cycle, quality stocks with highly predictable earnings and strong cash flow generation will outperform the broader market. As a firm, we have successfully guided our clients through several bear markets. Our experience gives us confidence that sticking to your investment plan, focused on your long-term financial goals, is the best course of action.
