May 20, 2014

A new T. Rowe Price study found:

  • Over the long run, the highest-quality stocks tended to deliver bigger gains relative to the overall market and to the lowest-quality stocks.
  • The highest-quality stocks built up this advantage particularly by doing better than the broad market and the lowest-quality stocks in down markets.
  • In rising markets, particularly after recessions, the lowest-quality stocks tended to outperform, however.
    In a presentation early last year, the late Jack Laporte, the longtime manager of the New Horizons Fund, described one of his investing tenets this way: "You seldom lose longer term by investing in high-quality businesses with durable models, high ROI [return on investment], strong free cash flow, and great management. The converse is also true—you seldom win long term by investing in lower-quality businesses. There are times to bet on mediocre businesses—generally at the bottom of economic and market cycles—but successful trades in below-average companies are very tricky."

Highest-Quality U.S. Stocks Outperformed Overall

A new study by T. Rowe Price's Quantitative Equity Group has identified the degree of outperformance of the highest-quality U.S. large- and mid-cap nonfinancial stocks over the broad market and over the lowest-quality stocks from 1991 through 2013, as well as the market environments when the highest- and lowest-quality stocks have tended to do best.

As detailed in the following charts, the study found:

  • The highest-quality stocks tended to outperform the overall market and the lowest-quality stocks.
  • These stocks particularly tended to outperform during months in which the market fell by at least 3%.
  • The lowest-quality stocks tended to outperform the market and the highest-quality stocks during months in which the market rose by at least 3%.
  • Periods of outperformance of high-quality stocks tended to persist for up to 24 months.
  • The same general trends were found among stocks in developed and emerging regions around the world.

For investors, these findings may seem obvious. After all, aren't high-quality stocks superior to low-quality ones by definition? The short answer: not in all market environments. For example, the lowest-quality stocks tended to outperform the highest-quality stocks when the U.S. economy was coming out of recessions.

"There are times when you want to buy low-quality stocks because they've become very cheap," says Sudhir Nanda, head of the Quantitative Equity Group and manager of the Diversified Small-Cap Growth Fund. "In a recession, investors chase safe, defensive stocks; they become more expensive; and low quality becomes cheaper—and so low quality tends to do well coming off the bottom of a market cycle. But over the long run, it pays to invest in high-quality stocks because you tend to have smaller down moves, so your returns can compound faster. It's really just simple math: If a stock drops by 50% in price, it has to go up by 100% to get back to where it was."

For Preston Athey, manager of the Small-Cap Value Fund, the overall concept at its simplest mirrors the market's proverbial fear-and-greed psychology. "When people are fearful, they bail out of the riskiest companies, the antithesis of high quality," Athey says. "On the upside, when those companies don't go bankrupt and animal spirits get going again, investors see they are so cheap that they may be able to offer the most bang for the buck."

Highest-Quality Stocks Outperformed Overall, for Years 1991 Through 2013

This study examined the average annual returns of the top 1,000 large- and mid-cap U.S. stocks—as well as their performance in months in which the Russell 1000 Index rose or fell in value by more than 3%.

It found that the highest-quality stocks outperformed overall, particularly by tending to significantly outperform the lowest-quality stocks in down markets. But the highest-quality stocks also tended to slightly lag the lowest-quality stocks in markets with the largest gains.

The stocks were numerically ranked in deciles from the lowest quality to the highest, based on such metrics as their volatility, capital allocation, stability of earnings, leverage, and return on equity.

The relative return of each stock then was calculated by taking its return and subtracting the return of the median stock in the set of 1,000 stocks.

The relative returns of the stocks in the top and bottom deciles of quality—expressed in percentage points of differential—are the relative returns for the median stock within the respective deciles.

High- and Low-Quality Stocks' Returns
Annual Average Relative Returns Percentage-Point Differential Monthly Average High vs. Low Percentage-Point Differential
Lowest-Quality Stocks Highest-Quality Stocks High vs. Low Rising Market Months Falling Market Months
-1.36% 4.09% 5.45% -2.90% 8.48%

Note: The list of the top 1,000 U.S. stocks was reconstituted monthly based on stocks' market cap changes. Financial stocks were excluded as their metrics vary from nonfinancial stocks.

Source: T. Rowe Price Quantitative Equity Group.

In Practice

In the study, high-quality stocks were defined as those with such characteristics as low volatility, effective capital allocation, stability of earnings, low leverage, and high return on equity.

For Nanda, these stocks often are "toll takers," regularly booking fees. An example: MasterCard, which gets a fee on every charge.

But in practice, the definition of quality isn't clear-cut. Among portfolio managers, there isn't a single definition of quality when it comes to evaluating stocks. Managers may stress different metrics, and thus define quality differently.

Moreover, T. Rowe Price managers usually employ other methods of stock analysis—including more qualitative methods—beyond purely quantitative assessments.

One key factor is an assessment of companies' managements. For example, Ray Mills, manager of the Overseas Stock Fund, pays close attention to how managements allocate capital. If they're not returning cash to shareholders so much, have they invested it well or made profitable acquisitions? "It tells you a lot about their future tendencies," he says.

"Another factor," says David Giroux, manager of the Capital Appreciation Fund, "can be market challenges. On paper, certain stocks may appear high quality, but they could face secular issues that lower their quality," he says, citing Microsoft, which has certain quality metrics but is in an increasingly competitive business.

Last, stocks' quality ratings can evolve over time. Indeed, the study found about 18% of stocks moved from the lowest-quality quintile to the highest over 24 months, and these tended to outperform over the next two years.

That's the core of Mark Finn's approach to managing the Value Fund, he says: "I try to find quality companies that have temporarily become low-quality companies—companies that have had controversies, become cheap, but that the market at some point will recognize as high quality again and pay up for them." United Airlines is a stock that has been on that trajectory, he says.

Even with these nuances, Giroux says, the long-term outperformance of the highest-quality stocks should be of interest to individual investors, rather than the often more exciting, "lottery ticket" stocks that sometimes lure them with the potential for big gains.

Over time, he says, most investors will tend to underperform with the "lottery" stocks and get much better risk-adjusted returns with high-quality stocks.

As of March 31, 2014, the Diversified Small-Cap Growth Fund did not hold MasterCard shares, and the Capital Appreciation Fund did not own Microsoft shares. The stock mentioned by Finn, United Continental Holdings, made up 0.9% of the Value Fund.

Highest- and Lowest-Quality Stocks' Performance Cycles

All funds are subject to market risk including possible loss of principal. Past performance cannot guarantee future results.