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Why Morningstar is using cheaper valuations to counter volatility

Why Morningstar is using cheaper valuations to counter volatility

Given stretched equity valuations and recent volatility, the temptation to seek shelter in lower risk holdings is strong.

For this reason, it is unsurprising that investors have become increasingly interested in ‘quality’ as an investible characteristic.

Quality is a somewhat fuzzy concept but typically describes companies that offer more stable profits and sound growth characteristics.

This combination of stability and growth can deliver excellent rewards for risk. However, our recent research in this area revealed some important considerations for the investor. 

One such consideration is the associated exposures that accompany a quality investment strategy. This is demonstrated by examining the constituents of the MSCI World Quality Index.

Despite its global mandate, more than 70 per cent of the index is invested in US equities. Furthermore, technology stocks are the main sector overweight within the MSCI World Quality Index, accounting for 36 per cent of the total exposure.

These dominant exposures have produced high returns over the last few years, yet when considered in a forward-looking context, presents an interesting dilemma. 

Investors’ want high-quality investments for their defensive attributes, but simultaneously find that the biggest relative overweight positions (ie, technology stocks, especially among US equities) could be grossly overvalued leading to lower future returns.

This exposure needs to be considered when we assess the prospective drawdown protection that a quality bias might offer, as it could differ significantly from historical patterns. 

One way of sidestepping this problem, and the one that we are most actively interested in, is to look at the quality landscape from a country or regional level.

This allows one to look through some of the concentration issues and focus on the most attractively priced areas of the market. In doing so, we find that in some markets quality stocks do appear considerably more attractive than market-cap weighted counterparts.

In fact, the relative opportunity appears to be especially pronounced in the US, where our expected return from quality companies exceeds our estimate of the return of the market-weighted index by almost 2 per cent a year.

Quality exposures in the European and emerging markets also appear to offer attractive valuations relative to the market-weighted equivalent, although Japanese quality appears to be expensive in both absolute and relative terms.  

For valuation-driven investors, the challenge is always to buy the best possible return stream at the lowest possible price. While quality assets are attractive due to the stability of their profits, the return you receive from these investments will ultimately be a function of the price you pay.

Investors in quality must therefore to be both selective in their analysis and contrarian in their nature.

Dan Kemp is is chief investment officer for Morningstar Investment Management (EMEA).

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