Have Lower Quality Stocks Really Outperformed?

Investor’s Corner with Jack Brown

It seems many stock market participants have been scratching their heads about the recent strong performance of what they perceive to be low quality stocks, and quite often cite the strong performance of small cap stocks as a case in point. The idea that money earned from smaller companies is of lower quality than that of larger more established businesses ignores the nature of profits.

As an owner of a business, you have an economic and legal stake in the earnings of that business. The price you pay for acquiring these earnings is a basic part of value investing. Consequently, understanding the nature of a business's earnings is fundamental to your potential return on investment.

Whether investing in a private company or shares of a publicly traded one, profits tend to benefit shareholders. Company management decides, whether implicitly or explicitly, to 1) pay out earnings in the form of a dividend, 2) buy back shares, or 3) keep the earnings for any number of reasons --- or a combination of these.

From an investor's perspective, dividends help directly by adding to the total return on investment. Share buy-backs, on the other hand, indirectly benefit investors by reducing the number of shares outstanding, thereby increasing the earnings-per-share for a similar level of total earnings. Finally, when a company keeps earnings, this tends to (but not always) benefits investors if a company uses earnings to grow.

Retaining earnings can lead to business growth by investing in new projects, expanding operations, acquiring other businesses, or other capital decisions. These activities tend to entail the risk of not being profitable, but this is the nature of equity investing and is one reason why we look for quality management.

Alternatively, retaining earnings may not benefit shareholders when companies have to dig themselves out of a hole. Consider a company with a heavy debt load, for example. In this case, retained earnings might be used to strengthen the balance sheet. This decision may be rewarding over the long run, but it’s more focused on fixing problems - not growth.

So, what are “high quality earnings”? When investment professionals talk about high-quality earnings (or high-quality businesses), the implication tends to be that these are of large businesses with products that are well-recognized. Yes, I can see the advantages of this: smoother revenues or earnings, global diversification, economic moats, etc.

From my perspective, however, high quality earnings are not the domain of large businesses with household-name products. High quality earnings are the domain of businesses that are positioned well to generate earnings that benefit shareholders (and not to fix holes). Getting too hung up on economic moats, name recognition, and global presence runs the risk of ignoring the nature of earnings. In the end, however, earnings quality is subjective (and there are many definitions).

Have low quality stocks really done better over the past 1-to-2+ years? I haven’t seen any studies on this, but linking good returns of small cap companies with low quality is mentioned with some regularity. Small cap indexes have indeed outperformed, but inferring that smaller businesses as a group are of lesser quality is inaccurate.

My view on earnings quality has always rested more on credit analysis, which does not jive with status quo. Albeit, from this perspective it happens that larger companies hold absolutely no advantage over smaller ones (based on the numbers – i.e. debt levels, etc.). In fact, the typical debt-to-equity level for the S&P 600 (small cap) Index stands at 0.4 versus 0.6 for the typical company in the larger-cap S&P 500.

Companies whose prices have done well since the credit crisis began have been those with strong balance sheets. In 2010, for example, companies with debt-to-equity levels less than 0.4 (the average for all companies in S&P's broad market index) out-performed their higher indebted peers by about 5% according to my analysis. This relationship, while not always the case, has held since 2008. Essentially, the market said, “moats are great, but how much money do you owe and to whom?”

Ironically, today there seems to be a pretty good supply of large companies with moats, solid credit qualities, and attractive valuations. As a result, I believe the head scratchers will be vindicated in 2011. The dispersion among stock performance, however, will be significant since there are also a lot of overvalued companies in both the large and small parts of the stock market – but still many bargains.

Jack Brown, CFA
jbrown@laureola.net
239-514-7642

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