Quality stocks: worth the hype or a pricey trap?

Investing in stability

Quality stocks have always been a magnet for investors. After all, who wouldn’t be tempted by the allure of top-tier stocks? Quality stocks are associated with solid investment performance and less downside risk. But isn’t this in contrast to what we have all learned in our introductory investment or corporate finance courses: higher risk (beta) is associated with higher expected returns? The finance professional’s equivalent to ‘No pain, no gain’. Doesn’t the general appeal of quality characteristics lead to higher valuations, impairing future returns?

Surely, there are times when quality stocks are not expected to perform particularly well, compared to, for instance, cheaper, more cyclically exposed stocks. When cyclical dynamics unexpectedly take a turn for the better, the latter group can show strong bursts of outperformance. But if predicting these cyclical shifts isn’t your forte, might it be wiser to stay anchored in the quality segment? Or will you then become the victim of the stocks’ potential overvaluation, the result of their attractiveness?

In this research article, we investigate quality stocks’ long-run performance, the extent to which they offer downside protection, their valuations, and growth expectations.

What are quality stocks?

Quality is a broad and somewhat vague concept, but it is often associated with more concrete, quantifiable attributes such as higher profitability, lower debt, and an overall lower cyclicality. All these attributes imply greater defensiveness. In a way, we could thus argue that these metrics are the fundamental equivalents of screening for lower volatility. Similarly, we could argue that screening for lower volatility is a more direct way to screen for defensiveness, compared to the more indirect way of screening for higher profitability or lower debt. In this article, we will put high profitability (return-on-equity), low leverage (or a high equity ratio), and low volatility (stock price volatility) side by side.

Returns for global quality stocks

The table below shows the annualised excess performance for roughly the last 15 years, for two fundamental quality metrics – equity ratio and return-on-equity – and a price-derived quality metric – volatility. Their performance is tracked in the three different regions that are part of the MSCI Developed Market indices: North America, Europe, and the Pacific.

The first thing that stands out is that in North America and Europe, it has especially been beneficial to avoid low-quality stocks. As for high-quality stocks, their excess returns have not been particularly positive in North America, but they have been in Europe. This might be explained by the fact that this has been a more turbulent period for Europe than for North America.

It’s different for the Pacific. In that region, the three quality metrics appear, on average, not to differentiate much in terms of accumulated return over this period [1].

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