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The Fall of Value and the Search for Quality

Summary:
It’s been a tough couple of years for value investors. Over the long term, value stocks have outperformed momentum and quality in most regions, sectors, and size segments. Since 2014, however, the opposite has been true. Between the first quarter of 2014 and the first quarter of 2016, momentum investing has proved dominant. Cumulative excess returns for momentum stocks reached 12.9 percent during that time, while so-called “quality” stocks delivered 4.7 percent and value stocks just 0.8 percent. In Europe, the divide is even wider, with momentum delivering excess returns of 28 percent, quality at 14 percent, and value at 3 percent.   Why has value fallen out of favor? Like many stories of asset underperformance, it begins with one of outperformance. Between late 2011 and 2013, value investing was in vogue, in large part due to the impacts of quantitative easing. The effort by the Federal Reserve, says David Rones, head of Credit Suisse’s US HOLT® Investment Strategy team, marked “the start of the monetary-policy fueled valuation expansion.” Investors, believing that the Fed’s quantitative easing portended declining risk and accelerating growth, gravitated toward the cheapest stocks that would disproportionately benefit from both. Between September 2011 and December 2013, the median price-earnings ratio for the cheapest European stocks rose from about 9 to nearly 15.

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The Fall of Value and the Search for Quality

It’s been a tough couple of years for value investors. Over the long term, value stocks have outperformed momentum and quality in most regions, sectors, and size segments. Since 2014, however, the opposite has been true. Between the first quarter of 2014 and the first quarter of 2016, momentum investing has proved dominant. Cumulative excess returns for momentum stocks reached 12.9 percent during that time, while so-called “quality” stocks delivered 4.7 percent and value stocks just 0.8 percent. In Europe, the divide is even wider, with momentum delivering excess returns of 28 percent, quality at 14 percent, and value at 3 percent.

 

Why has value fallen out of favor? Like many stories of asset underperformance, it begins with one of outperformance. Between late 2011 and 2013, value investing was in vogue, in large part due to the impacts of quantitative easing. The effort by the Federal Reserve, says David Rones, head of Credit Suisse’s US HOLT® Investment Strategy team, marked “the start of the monetary-policy fueled valuation expansion.” Investors, believing that the Fed’s quantitative easing portended declining risk and accelerating growth, gravitated toward the cheapest stocks that would disproportionately benefit from both. Between September 2011 and December 2013, the median price-earnings ratio for the cheapest European stocks rose from about 9 to nearly 15. The P/E ratio of the most expensive stocks, in contrast, barely moved, from just below 25 to just above it.

 

“[It was] a juicy market for value investors because value is, by definition, a mean reversion strategy,” said Rones at Credit Suisse’s recent 2016 HOLT Conference in London. “When there’s a big difference between cheap and expensive, you can make lots of money on that mean reversion.” Since 2014, however, valuation dispersion—the size of the gap between the lowest and highest valuations—has been near historical lows, motivating investors to focus more on momentum and quality. “When dispersion is high, that’s a great market for relative value investors,” said Rones. “But when dispersion is low, that’s when investors start thinking about things like growth, momentum characteristics, or quality—anything that differentiates stocks that are similarly priced.”

 

With high-momentum and high-quality stocks becoming increasingly expensive, one might reasonably ask whether another rotation is in the offing, this time in favor of value stocks. Rones says that the answer is likely no, because despite the recent outperformance of momentum plays, valuation dispersion remains low, which means there’s little opportunity to profit off of mean reversion. As a result, momentum and quality stocks likely offer more upside for investors in today’s market, despite their seemingly rich valuations.

 

Identifying Quality

 

So what exactly is a “quality” stock? That depends who you’re asking. Both MSCI and the hedge fund AQR Capital Management define a quality company as one with a high return on equity, low leverage, and steady earnings growth. Here’s where things get interesting, however: return on equity, one of the most popular measures of profitability, is an unreliable predictive indicator of future profitability. As are many other backward-looking metrics. So what’s a quality-seeking investor to do?

 

Credit Suisse’s HOLT Research group uses a proprietary metric, the cash flow return on investment, or CFROI®, which has proven far more effective at identifying quality companies than ROE. Using the HOLT framework, the bank designates two categories of elite quality companies, eCAPs and Super eCAPs. An eCAP is a firm with a history of persistent profitability, which HOLT characterizes as an empirical competitive advantage. To be designated eCAP, a company must sustain high CFROI for five years, have low CFROI variation, and sustainable levels of growth. The best of the eCAPs graduate to Super eCAP status, which they earn after ten years of CFROI outperformance.

 

In a test of competing quality-selecting methodologies, the Super-eCAPs metric detected quality companies with 92 percent accuracy while other metrics performed no better than 60 percent. When Super-eCAPs companies’ performance was examined during down market months, HOLT researchers found that 75 percent of Super-eCAPs stocks outperformed the market.

 

During major market declines, Super-eCAP outperformance has been even more impressive, as investors seeking safe havens turn to high-quality stocks with proven track records. In down markets, Super eCAPs outperform the market in three out of every four months. Super-eCAPs aren’t “flash-in-the-pan quality companies,” said Bryant Mathews, the Global Director of HOLT Research. “You need to have demonstrated really, really good persistence over quite a long period.”

Alice Gomstyn
My career began in newspapers, with my byline appearing in The Boston Globe and The Providence Journal, among others. I started working in web journalism in 2008, reporting on business for ABC News and later founding the network’s parenting blog. I’m now a full-time business writer and editor.

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