Is There Still a Payoff for the Quality Premium in Stocks? An Analysis

Of course, now that we know when the quality premium should work, just how do we use this information? First of all, we should view quality in the same light we view other factors like size and style in that it is subject to rotations in various market environments. In other words, quality—just like other risk and reward factors—does not provide a consistent payoff. In fact, payoff may not exist for extended periods of time. Across the decade from January 2000 to December 2010, for example, low-quality stocks actually outperformed high-quality stocks by 1.48% (annualized). More recently, however, the quality premium has been very much in vogue…in the third quarter alone, high-quality stocks outperformed low-quality stocks by approximately 10%. 

It’s difficult to predict with any certainty how long the current trend will continue as it will be highly dependent on the economy and the broader stock market. Still, we can conclude that high-quality biased strategies are doing a relatively good job of preserving capital right now, which to many investors, especially those with shorter time horizons, may be of primary importance when selecting a long-only U.S. equity investment. 

What Do We Do?

While we don’t even pretend to have a crystal ball that actually works, there are some unique developments today that tell us a lot about the potential return profile of high-quality stocks.  One of the more unusual is the relationship between dividend yields and the average 10-year Treasury yield.  

As the graph shows, dividend yields for the S&P 500 Index are in line right now with the average 10-year Treasury yield. Believe it or not, the last time these two yields were the same was in the 1950s. Given this relationship, we wouldn’t be at all surprised to see a dramatic new interest in dividend-paying stocks as investors search for yield. We’ve already seen a significant divergence this year between higher-yielding stocks and the overall market, as evidenced by the outperformance of the Dow Jones Select Dividend Index versus the S&P 500 Index. 

So is there a payoff for the so-called quality premium? Our analysis says yes…in time. And today might indeed be a good time. Between the search for yield due to historically low fixed-income rates, the significant valuation gap between high-quality and low-quality stocks, and the anticipated slow growth environment, we could see higher quality stocks outperform—no matter the direction of the market.

Author’s disclaimer: The views and opinions expressed are provided for general information only and do not constitute specific investment advice or recommendations from the author.