At the risk of sounding repetitive, there seems to be very limited upside potential for the stock markets of the industrialised countries over a three to five years time horizon from end-2009 levels. This may seem surprising after a decade of stagnation on the markets: however, it is the outcome of the extreme overvaluation of equities at the end of the 1990s. Nonetheless, the very low level of interest rates and the deterioration in public finances will keep investors on the look-out for alternatives to money-market and bond investments. In light of this, I believe that an active strategy is more than ever necessary when investing in equities.
One aspect of such a strategy involves trying to identify within markets regions, segments or companies that are undervalued or that have a better than average outlook. Currently, quality companies fit into this definition (by quality companies, I mean companies with low debt levels, a strong self-financing capacity and low fixed costs and generating a high return on equity). Whereas the rally on the markets in 2009 has resulted in many risky companies being overvalued once again, the valuations of companies such as Coca-Cola, Nestlé and Procter & Gamble do not seem excessive.
Simply buying the shares of quality companies is one option. A more defensive strategy would involve betting only on quality companies outperforming the market. While in the first scenario, investors will only generate a positive return if the stock price of the companies they bought increases, in the second scenario they will earn money if the stock price of these companies increases more than the market OR falls less than the market.
Currently, this second strategy makes sense for a number of reasons:
- First, we could argue that given that quality companies are intrinsically better than the average, they should outperform the market, which represents this average. This reasoning makes sense over the long term, but not necessarily over shorter time periods. Historically, quality stocks tend to underperform in two situations: when they have become too expensive, and/or in the first phase of recovery after a sharp slump on the markets. In this phase, investors tend to favor companies whose prices have fallen the most, or whose earnings are expected to rebound sharply;
- Both scenarios were present at the start of 2009. Quality stocks fell much less than the market in 2008 and starting in March, investors had begun anticipating an economic recovery and were buying cyclical companies and financials. Quality companies thus underperformed in 2009 (shown in the chart that compares the share price of Procter & Gamble and Johnson & Johnson with the Standard & Poor’s 500 index). A similar situation occurred during the stock market recovery in 2003;
Source: Bloomberg
- The situation at the start of 2010 is quite different, however. As quality companies underperformed last year, they are now reasonably valued in absolute terms, but cheap in relative terms – i.e. compared to the market and lesser-quality companies. Instead of trading at a premium, many of these companies are even trading at a discount to the rest of the market;
Price/Book Value: High Quality – Low Quality
Source: Datastream, Crédit Suisse Research
- A look at the history of the stock market shows that the outperformance of lower quality companies lasts on average around ten months. And since the start of the year, quality companies have indeed started to outperform the market again.;
- The economic environment will remain challenging and hopes of a sustainable recovery in the economy are likely to be dashed. This kind of environment is not conducive to lesser-quality companies outperforming.
Finally, the quality theme is linked to the dividend theme that I have highlighted on many occasions. One could in fact argue that the best indicator of the quality of a company is its ability/willingness to pay out a regular and growing dividend. The fact that in 2009, the stock price of the 137 companies in the S&P 500 not paying out a dividend has increased on average more than twice as much as that of the 363 companies that do, seems thus rather perplexing!
2012
