Buy “Quality”

Wall Street’s machinery has been calibrated to encourage activity from investors, often to their detriment.  To prod action, there are Wall Street analysts recommending “buys” and “sells” on individual companies along with a parade of market strategists who appear in the media to suggest the right strategy for the moment.  As one example, Barron’s recently ran its Fall Market Outlook, which helpfully included a “shopping list for fall,” highlighting sectors strategists recommend overweighting and underweighting.  Though many of these strategists are thoughtful and smart, and I often find value in understanding their rationale, I wonder who acts on these recommendations.  I envision someone reminiscent of the woman from the Interactive Brokers’ commercial a few years ago who had to excuse herself while at dinner with a companion in order to make some “hedging trades” on her phone in response to some breaking news.

I try not to be an investment snob, turning up my nose at those who choose to pursue a different path than we do at Provident.  We have time-tested reasons for our process, and ultimately believe our strategy positions clients well for achieving their desired long-term outcomes.  That doesn’t mean it is the only way or that you can’t find success YOLO-ing options on meme stocks such as GameStop or by investing in your favored cryptocurrency.  I would argue those paths make achieving long-term financial goals significantly less likely, but as the recent environment has shown, under the right circumstances one can find tremendous success.  We view investing as a serious business, yet that doesn’t prevent us from finding humor when someone makes a life-altering sum of money thanks to a cryptocurrency based on a dog that initially was intended purely as a joke.

Most alternative paths are more mundane than investing in dogecoin.  Like the Barron’s article, others often attempt to outperform by pursuing a path that involves frequently shifting sector exposure or making tactical portfolio changes.  We’ve all heard recommendations like “this is the time for value stocks (or growth stocks, etc.).”  However, making frequent portfolio shifts in response to the perceived environment is a particularly challenging path, and I bet most investors who pursue this approach underperform meaningfully over time.  Some can undoubtedly be successful, but success with that approach requires a particularly rare skillset.

Something that caught my attention recently was the recommendation from multiple strategists that “quality” stocks are what to own in the current environment.  “Quality” in this context generally means those companies with solid balance sheets, ample free cash flow, some level of revenue growth, and expanding profit margins.  I found this suggestion somewhat amusing given our approach.  At Provident, we certainly look to own quality names (at attractive prices) in all environments.  However, the strategists’ recommendation implies that there must be a time to own low-quality names—companies possessing dodgy balance sheets, questionable (if any) free cash flow, and challenged profit margins.  History says this might be true, but it requires more context, which I’ll address in a moment.

The current rationale for owning “quality” is the uncertain environment due to the substantial market run since March 2020, concerns around virus variants, inflation, the likely start of removal of ultra-loose monetary policy, and the deceleration of earnings growth.  It is a logical suggestion, given the less certain environment, that one might choose to own higher-quality names.

Alternatively, a more certain environment means riskier assets might be the preferred play.  Coming out of a meaningful downturn, where low-quality names typically get punished most, can be a great time to visit the low-quality bargain bin.  Buying a basket of stocks of companies that looked like they were doomed in mid-March 2020 likely would have resulted in a nice return.  After all, the worst-case scenario didn’t materialize.  The Barron’s article I referenced points out that the historical playbook says that coming out of a recession, you typically see low-quality stocks outperform for about a year, then the baton is passed to high-quality stocks as growth remains strong but begins to decelerate.

The purpose of this Viewpoint isn’t to announce a change in strategy for the next downturn.  In fact, consistent with our approach to seeking quality stocks at attractive prices, we used the selloff over a year ago as an opportunity to upgrade the quality of our clients’ portfolios.  We did this for several reasons, not the least of which is our application of a longer-than-typical time horizon.  In an industry that is so often focused on the short-term, we find there are many advantages to playing a longer-game.

While low-quality stocks might occasionally outperform over shorter periods, appropriately timing the entry and exit is an exceedingly difficult thing to do.  Even if you capture the period of outperformance, once it is over you are still holding what is likely an approximately fairly valued, low-quality stock.  Then what?  We find ownership of attractively valued higher-quality names typically offers a longer runway for outperformance.  This approach also incorporates some tax sensitivity.  Owning quality names and avoiding portfolio changes due to short-term tactical shifts results in lower portfolio turnover.  Ultimately the tax man will get paid but frequent portfolio changes can result in a larger tax bill, and sooner.

Finally, there should be some consideration for the path of stock movements.  Owning lower-quality names is like putting an amplifier on your nerves, as these stocks tend to be significantly more volatile. This makes it difficult to maintain equanimity in the face of what can be jarring ups and downs.  It is one thing to own a quality company with a fortress balance sheet during a market downturn; it’s something else entirely to hold a company that has a reasonable chance of defaulting on its debt.

Despite the opportunity for potential short-term outperformance, we plan on continuing to eschew tactical portfolio changes as we focus on the things that have been successful for our clients in the past.  Many strategists may currently believe that “quality” is the favored strategy, but that tends to be our focus in all environments as we feel it maximizes the opportunity for our clients’ long-term success.

James M. Skubik, CFA