Morningstar View: The quality outperformance conundrum

Expensive defensives or quality worth paying for in a low growth low return environment?

That is probably the single biggest question equity fund managers the world over are tussling with at the moment as high quality stocks continue their unrelenting outperformance of just about everything.

At this stage it would be helpful to take a step back and understand exactly what it is we mean when we talk about quality stocks. As is so often the case in the investment world, this concept can be identified by both qualitative and quantitative measures with the former often being quite subjective and the latter more objective. Qualitative definitions include aspects such as market share, competitive advantage or ‘moat’ and management - concepts that Terry Smith fund manager of the FundSmith Equity fund describes as “mostly woolly and much if not all of it”, in his view, “baloney”. Quantitatively, return on assets, return on capital, return on equity, five-year return on equity and leverage are some of the more common factors, of which return on equity is probably the most widely used. At FundSmith, quality companies are defined as those which over a business cycle are able to deliver superior returns on capital in cash. They must also have the ability to reinvest at least some part of those returns in growing the business and so compounding the returns, and which are able to do so without requiring leverage.

At the broadest level, these companies are most commonly found in sectors such as healthcare and consumer staples, including tobacco, although we should be careful not to confuse quality with simply traditional defensive stocks. The struggles of the utilities and telecoms sectors in Europe over recent years help illustrate this point. The relative outperformance of tobacco and healthcare over the last 5 years has been staggering. Tobacco stocks for example for the five years to the end of June 2012 are up almost 140 per cent while financials at the other extreme are down 35 per cent.

This trend has indeed been in place for longer and even if we consider the data over 10 years the trend is the same. At its broadest level it is therefore easy to see why funds that have been exposed to these themes and trends have significantly outperformed while those that have been underweight or void have struggled.

As always, the most important question is one of valuations. Are quality companies cheap, expensive or fair value? There are many ways in which we may consider this question both from a valuation perspective and indeed from both relative and absolute standpoints too. Valuation metrics would include looking at measures such as price to earnings ratios (PE), price to book (PB), dividend yield (DY) and free cash flow yield (FCF).