Why Quality Stocks are Mispriced

Even though quality companies trade at premium multiples, they still generate higher returns with less risk than the market.

Why?

Because of two major reasons. One behavioral and one fundamental.

Behavioral

The paper The Excess Returns of “Quality” Stocks: A Behavioral Anomaly suggests the disconnect between quality’s valuation and future returns stems from a behavioral issue.

The behavioral view posits that investors systematically underweight the information contained in quality-like signals (cash-flows, ROA, etc.). A possible story is misplaced focus: analysts and investors are too focused on other indicators such as Earnings Per Share (EPS), Momentum, volatility, etc. and fail to use all the information available in financial statements. Since accounting conventions that lead to the calculation of EPS paint a less reliable picture than the cash-flow statement (Sloan, 1996), cash-flows or ROA contain information that is relevant to value companies but might be insufficientlyused by analysts and investors.

The simpler behavioral answer is FOMO, the fear of missing out.

Quality companies tend to lag the market during good times and beat the market during bad times.

When the market is rising and animal spirits are riding high investors want to buy the stocks that are going up the most. These are usually fads and story stocks — companies with more hype than substance.

But when the business cycle turns these stocks tend to decline the most and investors ditch them for the stocks that are faring better. These stocks are usually backed by companies with real businesses that lead their industry, with low debt levels, generate significant cash flow, and can use their lead position and cash flow to gain market share while their competitors struggle. Also known as Quality companies.

Fundamental

Polen Capital looked deeper at Quality’s returns across the full business cycle.

Polen confirmed that in the early stages of the business cycle quality companies underperformed the most. The early stage of the business cycle is the initial recovery phase from the previous recession.

Which stocks go up the most during the first part of a recovery? Usually, it's the stocks that went down the most. The fad and story stocks.

The stocks that performed the worst during the early stage recovery were the stocks that went down the least during the recession because there was less to recover. Like the stocks of quality companies.

Then Quality keeps up with the market and slightly outperforms during mid-cycle.

But then in the the late stages of the growth cycle and during recessions, quality companies outperform. Again, they are real businesses with strong cash flows and the ability to gain market share during periods of stress.

Capture Ratio

The capture ratio explains the full business cycle outperformance of quality companies.

Quality companies may miss out on the big rebound in the early phase of the business cycle but overall keep up with the broad market according to Polen Catpial’s data.

Let’s say their upside capture ratio, the percentage gained during periods of positive market returns, is around 95%.

But when the market turns down they lose less than the overall market. Let’s use 85% as their downside capture ratio.

Over a full cycle, the total Capture Ratio is 1.12, 95%/85%.

Then repeat over many business cycles and you get the long-term outperformance of quality.

Quality companies rarely trade at a deep discount to their growth potential and fair value. However, the behavioral missteps of market participants, at times, create an opportunity to buy Quality companies at a very favorable price that doesn't fully account for their lower volatility and long-term secular growth.

That slight mispricing helps generate long-term outperformance.