One unique aspect of the 2022 bear market to date has been the inability of high-quality companies to register less downside. Measured by the MSCI All Country World IMI High Quality Index, high quality equities are down 24.34% year to date through June 30th, or 416 basis points worse than the standard MSCI All Country World IMI index. This has been fairly universal with the “quality drag” applying across regions of North America, Europe, and Asia. The quality tilt has also underperformed across company size including small cap, mid cap, and large cap. Some of this has been structural in terms of the sector composition of these indices, but with higher interest rates, slowing economic growth globally, and the valuation reset, we don’t look for this phenomenon to continue.
Since 2008 when this Quality index became available, the quality style significantly outpaced the standard index during times of market weakness before this year. Quality generated outperformance ranged from 204 to 891 basis points on a calendar year basis over the years 2008, 2011, 2015, and 2018. Notably, this included periods of both rising and falling interest rates. Year to date, however, higher quality has suffered. Although the larger weight in the Information Technology sector and lesser weight in the Energy sector accounted for approximately 59% of the underperformance by the Quality index, the quality factor drag was almost universal, negatively impacting returns across nine of eleven sectors. This is best explained by the interest rate surge, as the Federal Reserve and other central banks pivot away from accommodation. Quality usually trades at a valuation premium and its recent price adjustment has been greater due to higher interest rates more steeply discounting future earnings. Indeed, the Quality index experienced a dramatic price-to-earnings multiple compression from 23.2 times to start the year, a 27% premium to the standard index, to 16.6 times now, a much more typical 12% premium. Hence, the relative valuation adjustment should be close to complete.
Quality demands a premium valuation due to the better scoring of key characteristics, including balance sheet strength, profitability, and earnings volatility. Companies with stronger balance sheets rely less on external sources of capital like debt and require less follow-on equity financing, which can dilute existing shareholders. This financial strength becomes more important during recessions and times of equity market weakness, since quality companies are able to acquire attractively-valued assets when weaker companies need to downsize or have their expansion limited due to their debt load. Companies with a lower debt-to-equity ratio have dry powder to take advantage of cheaper valuations, enabling acquisitions to expand operations profitably. These companies are also in a better position to maintain cash dividend payments to shareholders, or buy back their own stock.
Companies showing better profitability, that is, generating a higher return on invested capital, require less investment for a given profit gain. If sustained throughout the business cycle, this signals a competitive edge such as an unassailable cost advantage, greater customer loyalty, or dominating market position. These companies enjoy pricing power, cushioning the damage from an economic downturn. Pricing power also helps these companies generate profit growth exceeding the rate of inflation.
Another very important indication of profitability, and probably not appreciated to the extent it should be, is the proportion of cash in a company’s reported earnings. Not all corporate earnings are created equal, and unfortunately, reported numbers may not accurately reflect the economics of the business. Necessary adjustments can be numerous and vary by industry. One notable example of non-cash impact is the ”full cost” accounting method in the Energy Exploration and Production industry. Justified by the idea that the company does not know how successful a drilled well will be, this accounting method amortizes the costs of unsuccessful wells over a period of years instead of expensing the costs as incurred. This results in reported earnings exceeding cash earnings for companies using this full cost method. Chevron, a holding in our global equity portfolios, uses the more conservative “successful efforts” accounting method, while Devon Energy uses the full cost method. Thus, the reported earnings of these companies are not directly comparable. Another example of significant noncash impacts is “program accounting” in the aerospace industry. Used by Boeing, this technique does not use the actual incurred costs of building a plane sold during a reporting period but uses the predicted average cost over the estimated total number of planes sold, which spans years into the future. The accounting method assumes lower costs in later years based on a manufacturing learning curve leading to improved efficiency. Obviously, such projections can be wildly inaccurate as witnessed by the 737 Max, where the fixed cost allocation will be spread over a much-reduced number of planes sold than initially assumed. Moreover, as these examples illustrate, companies with a high proportion of noncash earnings items should be considered lower quality.
Finally, quality companies usually post lower earnings volatility, experiencing less peak-to-valley changes in earnings and free cash generation. This provides more consistency compared to peers and gives investors greater confidence in the company’s future.
As painful as this bear market has been, we view some aspects as being healthy. The market reset has reintroduced some much-needed rationality by removing a good portion of the excessive premium for a number of extreme, almost silly-valued stocks. Shopify and Netflix, for instance, come to mind. That said, it has been incredibly irrational in our opinion in that the market has been indiscriminate in punishing many of our high-quality companies to excessively low-price levels regardless of their superior long-term outlook. Although bear markets like this one have unique characteristics, it’s important to remember they all have one thing in common. They eventually end. When this one ends, there are many ultra-cheap, higher-quality companies that will post significant price appreciation. In our global and ADR strategies, we believe we own many of these quality companies, and the quality trait is one which never goes out of style for long.