Part of the tricky job of stockpicking is not simply finding cheap nuggets that have been written off by the market, but knowing when to accept the received wisdom about companies’ earnings, operations, and the high prices the stock market can occasionally attach to them.
Sometimes, good investing means accepting that the wheel has already been invented, and that what matters more is how fast it turns. But this year, it so happens that investing in quality US companies comes with a big potential kicker, in the shape of a significant value correction. To wit, the forward price/earnings multiple on BlackRock’s MSCI USA Quality Factor (IUQA) exchange traded fund – which gives investors passive exposure to large and mid-cap US stocks with strong quality fundamentals – has fallen from almost 25 to less than 18 in just 12 months.
Last year, investors worried about paying too high a premium for the very best US companies. This time, while valuations haven’t completely collapsed, the main issue for US stock pickers is the perceived quality and resilience of corporate earnings. The beauty of quality companies is that this comes as part of the package.
The sheer size of the US market and economy means that the likelihood of finding under-the-radar quality companies is higher than in an equivalent UK index. Our search is again conducted using our High-Quality large cap screen, a perennial Investors’ Chronicle favourite. Since launch in 2011, the UK version of the screen has returned 450 per cent compared with 126 per cent from the FTSE All-Share.
Last year, our picks from the screen’s results avoided the technology stocks that were powering the returns of both growth funds and broader market indices. Instead, they reflected the general scepticism of our writers towards valuations that assumed forever growth at a very high level. Unfortunately, humans are pre-programmed to run with the herd so avoiding irrational exuberance requires stamina and discipline.
Part of this comes down to the basics of good company analysis and evaluation. This would have identified early on the defects of running a platform with low barriers to entry, such as the problems Uber (US:UBER) has with low-cost rivals, and the danger of competition from deep-pocketed rivals: Netflix (US:NFLX) plans to spend $17bn on content, whereas Disney (US:DIS) can splurge $30bn. Then there is the realisation that many technology companies depend on consumers having spare cash for discretionary spending on their products. The ‘hold-the-headline’ news is that this year those consumers don’t and they are shedding services of all kinds with a ruthless eye to costs.
None of these companies would pass the screen’s tests. But as this year’s results show, the rigours of our metrics do not close the door to all tech businesses.
But what makes for a quality company? Price can play a role in this calculation, but one lesson to take away from the past 12 months is that share prices can fall, even when operating margins or cash flow don’t. Never underestimate the sentiment premium on top of every quality share. That aside, the screen is designed to capture a very specific set of criteria.
The chart below, which includes dividends and is priced in sterling, shows the strong performance of the four companies we wrote about last year.
It is also worth noting what is not covered. The screen is particularly focused on high margins, which tends to exclude those firms that generate large profits on high volumes but with low-margin returns – the best of the bulk retailers, for example. Equally, some companies’ high spending on long-lasting intangible assets such as brand awareness or intellectual property can depress reported profits and margins – given they are often treated as day-to-day costs. This can lead to the under-counting of assets and assumes that companies have invested less to achieve their position than is the case.
But, again, that is not an insurmountable barrier, as demonstrated by the presence of one of the world’s most intangible-heavy companies among this year’s selection. In the pages that follow, we analyse the potential four companies that are highly ranked by the screen.
