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Home > Opinion > James Bateman

Stock quality is key to finding a safe haven

Managers should begin by seeking stocks with a consistently higher than average return on equity combined with lower debt-to-equity

By James Bateman | Published Jun 27, 2012 | Investments | comments

Even the best contrarian investor will tell you that there are times when following, and not going against, the herd, is the right strategy. Last week I wrote that “quality” was looking expensive compared to other stocks, and questioned how long this would persist. However, many investors do want a safe haven within equities, so an article on what this is seems timely.

Firstly, we can dismiss pure passive broad market index replication as definitely not offering a safe haven: the growing popularity of passive investing in the mid-2000s saw many investors make substantial losses as these strategies by definition returned 100 per cent of the equity market losses of 2008. Active strategies with a beta less than one might seem a logical answer, since beta is a measure of sensitivity to equity market movements. But beta by itself is inherently backward-looking and it is sometimes the case that a manager that is perceived as low beta (perhaps having seemed so in gently trending up markets) is anything but in a market crisis.

Separation of beta into bear and bull components is hence statistically useful but this is still too simplistic to be effective in selecting the right managers as safe havens. Equally, it is easy to argue that “cheap” stocks (so a “value” investment style) should be a safe haven as what is already cheap should have less potential for further downside. However, as I argued in an article some weeks ago, the risk of value traps and the extent to which valuations can become depressed in periods of volatility mean that value investing is not in reality a safe haven.

Instead, one way to define a safe haven is a group of stocks that are characterised as offering high quality – solid and sustainable returns on equity, good free cashflow generation, and a low level of leverage. Companies such as these have proven themselves able, over successive market cycles, to consolidate their dominant market positions, and, in times of crisis, frequently gain market share through either the demise of their competition or by making acquisitions at bargain basement prices. Such deals require a high level of cash on the balance sheet (since debt is difficult to obtain in crises) – another sign of a quality business.

Managers with established processes who are consistently seeking out higher quality stocks at reasonably attractive valuations can offer good performance, on a relative basis, in periods of high market volatility. However, there is no one method to finding “quality” stocks, and while broad themes can be applied across all geographies, there are also some more region-specific approaches that can be used. Simplistically, managers seeking stocks with a consistently higher than average return on equity combined with lower debt-to-equity, and a positive qualitative assessment of factors such as competitive positioning, brand strength, barriers to entry, and so on, can provide the basis for an effective quality strategy. Implicit in this approach is a rejection of the assumption that companies suffer from “fade” to a “normality” of the industry or sector average. Valuation is, though, an important component of any quality-biased strategy as at times in the market cycle an excess premia can be applied to these “quality” stocks, and so a degree of rotation based on relative valuations is important. Traditional metrics, such as price to book, are commonly used to value quality businesses, often with a very long time horizon.

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