Over the last couple of years, we’ve all heard how the collective rush to low-quality stocks has left active, long-only equity managers in a vacuum. True enough, from March 2009 to June 2011 the S&P 500 Low Quality Index outperformed the S&P 500 High Quality Index by an astonishing 1,100 basis points. Since so many of the managers we cover at Prima Capital have a high-quality bias, it’s particularly important that we understand the logic behind this reality, if there is any. To that end, we want to take this opportunity to dig a little deeper into the ‘high quality versus low quality’ debate to see if there really is a payoff for the so-called quality premium.
First, let’s set an acceptable definition for quality. Given that the vast majority of professional money managers use the S&P Quality Rankings to characterize their common stocks, we believe this is the best definition for quality. More than that, the Quality Rankings, which by S&P’s definition reflect the long-term growth and stability of a company’s earnings and dividends, can also be used as a proxy for risk. Several academic studies, most notably those of Muller and Fielitz in 1987 and Felton, Liu and Hearth in 1994, found a close relationship between a common stock’s S&P Quality Ranking and its beta and standard deviation of returns.
With all of that as a given, we can then hypothesize this: High-quality biased strategies should provide above-average downside capture statistics and below-average upside capture statistics.
What Do We Know?
As the chart below shows, high-quality stocks, with the exception of 2008, protected investors on the downside and trailed the gains associated with low-quality rallies. We consider the outlying year to be unique in that the massive hedge fund de-leveraging brought on by the credit crisis put outsized pressure on high-quality stocks. The resulting price declines reversed themselves in 2009, allowing investors to recoup these losses.
Our internal analysis of the Morningstar mutual fund universe supports this observation. Employing a broad range of quality factors, including ROE, low debt-to-capital ratios, high and consistent dividend yields, and long-term earnings growth, we found a statistically significant relationship between quality and the direction of the market.
Specifically, our work confirmed that high-quality factors offered downside protection during market downturns while low-quality factors outperformed in outsized market rallies.
What If It’s Different This Time?