We’re entering earnings season, when companies look back on the past quarter and maintain or revise full-year guidance to investors and sell-side analysts. This time around, corporate earnings appear weak, with only consumer discretionary and telecommunications shares expected to experience double-digit growth in the third quarter. Most analysts expect little improvement in the fourth quarter as well, but low expectations may actually be the friendliest dynamic facing the market.
With the earnings picture looking bleak, investors may wish to examine their allocation to high-quality stocks. Quality stocks are typically issued by companies with high returns on equity, strong balance sheets and stable earnings growth. There are several good reasons to embrace quality shares.
The rationale for quality
- Attractive stock characteristics. High-quality companies have characteristics that are attractive to investors, regardless of market cycles. They tend to generate strong return on equity (ROE) and throw off lots of free cash – fundamental indicators of strength that set them apart from weaker competitors.
Return on equity is a barometer of how shareholders are rewarded for their invested capital – with a higher number indicating a greater degree of profitability. As shown in the graphic below, ROE for the S&P 500 Index has begun to crest, and the ROE spread between the S&P 500 High Quality Rankings Index and the S&P 500 Index has increased in recent years. This suggests that high-quality companies are delivering more profit per invested capital than the market as a whole.
Free cash flow measures cash available to a firm after accounting for capital spending. It’s an indicator of how much cash a company has available after making investments to sustain and expand its business. Free cash flow can be used to pay down debt, reinvest in the business, raise dividends or repurchase shares. Since June 2011, free cash flow for the S&P 500 High Quality Rankings Index has risen from $115 to a recent high of $163 per share.1 During this same period, free cash flow for the S&P 500 Index has seen little change, and now stands a little north of $104 per share – indicating that quality companies have generated significantly more cash than the broader market over the past four years.1
- Earnings as a potential source of market volatility. Tepid earnings have muddied the corporate profit outlook, raising the specter of market volatility. In my view, this could be advantageous to quality shares, which have shown relative strength during periods of escalating volatility. The graphic below plots the ratio of the S&P 500 High Quality Rankings Index to the S&P 500 Index against the three-month average level of the CBOE Volatility Index (VIX) — a measure of near-term volatility. A rising red line denotes increasing volatility, while a rising blue line means that the quality index is outperforming the broad market. You can see that the S&P 500 High Quality Rankings Index has tended to outperform over time – especially during periods of high volatility. (Similarly, quality stocks can lag during periods of falling volatility.)
- Attractive valuations. Because they are able to generate high ROE and strong free cash flow, it would not be surprising to see stocks issued by quality companies priced at premium valuations. But, as the chart below suggests, quality stock valuations remain reasonable based on three metrics.
- Earnings per share. The S&P 500 High Quality Rankings Index is priced at 17.80 times earnings per share, compared with 16.99 for the S&P 500 Index. This 0.81 premium is almost right in line with the average seen since June 2011.1
- Cash flow. The S&P 500 High Quality Rankings Index is priced at 11.98 times cash flow compared with 10.49 times cash flow for the S&P 500 Index. The spread of 1.49 is below the 2.28 average seen since June 2011. 1
- Sales. The S&P 500 High Quality Rankings Index is priced at 1.51 times sales, compared with 1.69 times sales for the S&P 500 Index. The 0.18 discount compares with an average discount of 0.21. 1
The PowerShares S&P 500 High Quality Portfolio (SPHQ) is an option for investors who desire equity exposure, but are concerned about volatility and the outlook for corporate profits. The fund tracks the S&P 500 High Quality Rankings Index and is designed to provide exposure to high-quality stocks within the S&P 500 Index.
1 Bloomberg, L.P., Oct. 2, 2015
The S&P 500® High Quality Rankings Index is designed to provide exposure to the constituents of the S&P 500 Index that are identified as stocks reflecting long-term growth and stability of a company’s earnings and dividends.
The CBOE Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility.