3 things that might surprise you about quality stocks

I made a promise in my last blog post: To continue the conversation on quality stocks by delving into sector, size and cost considerations. Each of these can be subject to misconceptions. Today I hope to offer some clarity ― and maybe even bust a few myths in the process.

Myth #1: Defensive sectors offer higher quality

We believe investors can find quality in every sector, and would caution that the popular wisdom doesn’t always apply. Sectors traditionally associated with quality, such as consumer staples and utilities, generally are not screening high on our quality metrics today. Their valuations have become elevated and business fundamentals are less compelling than in some of the faster-growing segments of the market.

The misconception may be partly definitional. Investors often boil quality down to stability. Utility stocks (often considered bond proxies) offer earnings stability and attractive yield by paying out a fixed percentage of their net income in dividends. For that reason, they may fittingly wear the “stability” label ― but that doesn’t necessarily earn them the quality badge.

We view a company’s ability to grow its dividend as a better quality indicator than its prevailing dividend yield. The payment of a sustainable and growing dividend is a sign of capital discipline and prudent capital allocation on the part of a company’s management team.

What sectors are scoring well on our quality screens today? Health care and technology stand out. The latter defies the idea that quality can’t be found in cyclical sectors. In fact, many tech companies are showing balance sheet strength as well as growth in both earnings and dividends. In health care we like HMOs. The industry is consolidating, and we see earnings becoming increasingly stable as a result.

icon-pointer.svgRead how Tony defines quality.

Myth #2: Bigger is better for quality

It would stand to reason that stocks with solid balance sheets, strong cash flow and the ability to execute shareholder-friendly practices such as stock buybacks and dividend increases would be the larger, well-established franchises. This is often ― but not always ― the case.

We applied the proprietary 12-factor assessment of quality that we use in the BlackRock Equity Dividend Fund across the Russell 1000 Index, looking at a 40-year period. We found no correlation between market cap size and the quality of the individual companies in the index. The current cycle also has brought business models that did not exist before ― and more opportunities to mine for quality. These companies don’t necessarily start out big.

New business models present both opportunities and risks. Their newness means they are difficult to value. The market can be slow to recognize the quality nature of new ideas, providing an opportunity to capitalize early. Two recent examples: app-driven ride services that have disrupted traditional means of transportation, and multi-channel media and entertainment services that have displaced DVDs. Of course, some new businesses may not pan out or hold up to scrutiny over time. It’s important to look at the competitive landscape and to do the math to determine if a company’s return on invested capital is sustainable.

Myth #3: Quality will cost you

We often expect to spend more for a higher-quality item. That’s not necessarily true for quality stocks today. Our research, using that same multi-factor assessment of quality but this time looking at valuation, revealed that the highest-quality stocks are “on sale” relative to the lowest-quality stocks today.

The chart below illustrates the point. A reading below 1 indicates higher-quality stocks are trading at a lower price-to-earnings multiple than the lowest-quality stocks. This has been true for much of the past 10 years, since the economy emerged out of its last recession. History suggests quality stocks can trade at a premium during recessions. This tells us two things: Investors can buy quality stocks at a below-average price today, and these stocks’ valuations could grow down the road as markets begin to anticipate the next recession.

Bottom line

Amid market volatility and an aging economic and business cycle, quality becomes more important for investors. We believe the price is right, and see a lot to like about quality, dividend-growing stocks in today’s late-cycle, low-interest-rate world.

Tony DeSpirito is Director of Investments for U.S. Fundamental Active Equity and a regular contributor to The Blog.

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