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Strategy Lab

Why 'quality' stocks can drag down your portfolio Add to ...

Norman Rothery is the value investor for Globe Investor’s Strategy Lab. Follow his contributions here and view his model portfolio here.

Value investors have it easy.

Sure, they hold stocks other investors fear and loathe, but it’s relatively easy for them to find such unloved dogs. They just have to look for shares that are cheap in comparison to sales, earnings and other standard yardsticks. Over the years, many of these simple approaches to buying value have managed to beat the market.

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A far bigger challenge is making money with quality stocks. For decades, investors have pursued profitable quality stocks just as eagerly as gold prospectors once sought out the mythical city of El Dorado – but apart from a few exceptional individuals like Warren Buffet, they’ve encountered no more success than the early gold hunters.

This failure is hard to explain. Quality stocks should represent highly profitable businesses with sustainable competitive advantages. But these sterling enterprises don’t seem to produce outsized returns for investors – at least, not for those who look for quality by the numbers.

Maybe quality is just too elusive to pin down by quantitative measures. Or maybe quality is so obvious that everybody can spot it. If so, quality stocks may get bid up to the point where they can no longer generate market-beating returns.

Whatever the reason, there is a long and dismal history of looking for quality by the numbers. James O'Shaughnessy’s latest edition of What Works on Wall Street provides the lowdown on three failed attempts to find the market’s city of gold.

First up: net profit margin. This shows which firms earn the most for every dollar in sales and is commonly treated as a proxy for quality.

Mr. O’Shaughnessy shows that a portfolio of large U.S. companies with exceptionally high net profit margins gained 8.5 per cent a year on average from 1964 to 2010. Not bad – but the market fared even better, advancing 10.2 per cent a year. On average, an investor who bought quality stocks based on their high net profit margins would have lagged the index.

So let’s turn our attention to two other quality measures: return on equity (ROE) and return on assets (ROA). High scores on these indicate that a company can generate big returns from shareholders’ cash and from assets.

Both measures are often treated as marks of quality, but according to Mr. O’Shaughnessy, stocks with the highest ROEs gained 9.5 per cent per year from 1964 to 2010 while those with top ROAs climbed 9.7 per cent annually. Again, both trailed the market.

Such flops haven’t stopped researchers from looking for more effective ways to earn money from quality stocks.

Several recent studies examined a new measurement that is similar to ROA. Instead of comparing earnings to assets it compares gross profitability to assets (GPA). Gross profitability is equal to a firm’s revenues minus its cost of goods sold. It’s a relatively clean measure that isn’t influenced by many common accounting shenanigans.

In their new book Quantitative Value, Wes Gray and Tobias Carlisle found that stocks with the highest 10 per cent of GPAs outperformed the market by 2.1 percentage points annually from 1974 to 2011. Those are eye popping returns for a single quality indicator.

Mind you, the impressive results could be due to a little unintentional data mining. If you look through a slew of quality measures, you’re likely to find one with a good track record simply as a result of chance. Such spurious findings have a nasty habit of disappearing over time.

In addition, stocks with high GPAs might not fit everyone’s notion of quality. For instance, stocks in the S&P/TSX 60 that currently score well on GPA, according to S&P Capital IQ, are Shoppers Drug Mart, Loblaw, George Weston, Tim Hortons, Agrium – and Research in Motion.

Research in Motion? Yes, you read that right.

Perhaps the most reliable lesson to emerge from the hunt for investing’s El Dorado comes in the form of a warning. Mr. O’Shaughnessy’s research shows that while firms with extremely high net profit margins, ROEs and ROAs don’t generate great returns, companies that score particularly low on these measure fare much worse than the market.

High quality stocks might not make you rich, but low quality ones have a good chance of making you poor. That’s a quality message by any standard.

 

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