The Quality Conundrum

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We are witnessing the end of a remarkable and confounding era for stocks, best described by the “quality conundrum” investors faced for much of the last two years. During that time the combined outperformance of low-quality stocks alongside the underperformance of high-quality stocks was unprecedented in the last 30 years.

Now, we are embarking on an era where high-quality stocks will likely significantly outperform low-quality stocks, resolving this conundrum. Regardless of how you manage money for your clients, understanding this impending regime change will be critical to delivering superior performance.

The resolution of the quality conundrum will proceed independent of the overall market’s direction. This is important because the third, and perhaps final, painful decline of the current secular bear market remains ahead. Against that backdrop the renewed outperformance of high-quality stocks may begin as a flight to safety, but can continue as the seedlings of a new secular bull market, eventually driving market indexes higher. Attractive absolute valuations of many high-quality companies – those trading at single-digit P/E and cash-flow multiples, around tangible book value, and with respectable 3-6% dividend yields – will be the foundation for those eventual gains.

By reviewing the nature and magnitude of the quality conundrum investors have faced of late, we can begin to understand how it will resolve and how to take advantage of the looming shift. 

A conundrum among many

The market has a way of frustrating even the most patient investors. Value investors who correctly identified the expensive valuations of large-cap equities in the late 1990s spent several years watching those overvalued markets become even more so. Investors who correctly identified the nominal lows in stock prices in 1974 had to wait another seven years for their investments to begin compounding at meaningful real rates of return. In November 1979, investors who watched gold appreciate over 1,100% in less than 10 years – and were sure that, at $400/oz, its pricing was unmistakably speculative –  must have been shocked to see prices double once more to over $850/oz over the course of the next few months. As the eminently quotable John Maynard Keynes noted, the market can stay irrational longer than most investors can stay solvent. This, no doubt, is a lesson learned and relearned throughout history.

Fortunately, for those investors who aim to stay solvent and generate a meaningful return along the way, the occasional irrationality of market prices has a counter-force – mean reversion. This phenomenon is driven by valuation, which as James Montier points out, is the closest thing we have to a law of gravity in finance. . In the Seven Immutable Laws of Investing, he identifies valuation as the primary determinant of long-term returns, and countless academic studies back up that assertion.

Those focused on valuations were pleased to see stocks trading around 700 on the S&P 500 in March of 2009. At a normalized P/E of 13, the market was priced to deliver decent returns for the foreseeable future, approximately8-10% annualized. Investors of nearly all types, in nearly every risky asset class, saw tremendous value. Only those paralyzed by fear or a lack of liquid capital were unable to benefit from the cheapest market we had seen since the mid 1980s.

The joy of inexpensive markets faded rather quickly, however, as the S&P 500 rallied more than 40% over the subsequent six months and went on to appreciate by more than 75% from its March 2009 low by the end of 2010. In essence, the promise of 5-10 years of 8-10% annualized returns was compressed into just a handful of quarters.

Skeptics have observed that more than just fundamentals have been driving stock prices over the last few years. Whether it was crisis-induced fiscal and monetary policy, rampant global liquidity from expanding central bank balance sheets, or greed’s influence on “animal spirits” – something just didn’t feel right about the nature of the stock market’s rally from the March 2009 lows.