THE BEST TIME TO BUY QUALITY STOCKS IS NOW / THE FINANCIAL TIMES OP EDITORIAL

The best time to buy quality stocks is now

A generational opportunity in otherwise bubbly markets

Ruchir Sharma

© Matt Kenyon

Amid mounting fears of an artificial intelligence-led bubble, many investors feel trapped between the optimists who say high valuations for stock prices make sense because AI is the biggest tech revolution ever, and pessimists who say this time is no different and any bubble eventually deflates. 

The trap feels deeper for lack of options, since gold, bonds and other havens also look pricey.

But there is a once-in-a-generation opportunity in global markets that could deliver strong returns regardless of how AI mania plays out. 

The opportunity is in quality stocks, particularly those trading at relatively inexpensive prices. 

As defined by MSCI indices, “quality” stocks are characterised by high return on equity, stable earnings growth and low debt levels.

Worldwide, only about one in five stocks make the cut, and over the past three decades they have steadily beaten the market as a whole and other investment strategies such as growth or value. 

For that reason quality stocks are often expensively valued. 

But that is not the case today.

Quality just suffered one of its worst relative declines ever in developed markets, lagging behind the broader market by almost 10 percentage points over the past year. 

And in emerging markets, quality stocks have experienced the worst relative decline ever, trailing the broad index by 17 percentage points over the past year.

So while the US-dominated global stock market averages are pricey and trading well above their historical trend, the quality corners of those markets are trading below trend. 

Typically, quality stocks have delivered their best returns after similar (but rare) periods of underperformance, which is why this moment feels so ripe. 

Intriguingly, quality has underperformed despite significant exposure to Big Tech. 

Of the magnificent seven companies driving the AI rollout, five pass the tests for “quality”. 

The presence of names like Alphabet and Microsoft did not, however, stop the class of quality stocks from falling behind, because it included none of the low-quality stocks that have been getting a huge lift from a wave of liquidity-driven speculation.

Typically these low-quality stocks are highly indebted, unprofitable and volatile, and they have been soaring of late, driven by retail investors and big hopes for AI. 

This year, the returns of high-quality US stocks are less than one-seventh those of “unprofitable tech”, which is up 70 per cent. 

Seized by speculative fervour, investors have also ignored many sectors and countries that are heavy with quality stocks, including, for example, healthcare and consumer staples in developed markets.

Battered by a sense that everything from stocks to gold looks expensive, some long-term investors are retreating from the markets, saying recent price movements are too perilously “irrational”. 

Others are turning defensive by holding plenty of cash, even though that is yielding low returns after accounting for inflation. 

There is nonetheless a way to generate decent returns in this environment. 

That’s by buying quality stocks. 

One way to do this is through quality-labelled ETFs, which are listed on various exchanges.

The real sweet spot right now, however, would be in a quality portfolio stripped of the most overvalued stocks. 

To find these potential gems I ranked companies in the US, in other developed markets and in emerging markets for “quality”, refining the MSCI standard by strengthening the profit measures and adding one for earnings growth. 

I filtered out companies that are small, illiquid, subject to volatile price swings or red-flag practices such as unusually generous stock compensation packages. 

Finally, I screened for value based on free cash flow yield and price to forward earnings — which dropped most richly valued Big Tech names.  

The result is a list of around 400 high-quality stocks trading at attractive valuations, including nearly 140 in the US and just over 40 Chinese companies listed in Hong Kong. 

Clusters of these stocks can also be found in the UK, Brazil and India. 

By sector, more than 20 per cent of this undervalued, high-quality class are industrials, followed by financials and consumer discretionary.

Homing in on the largest stocks, with a market cap above $10bn, yields many household names. 

The top 30 in each category — US, other developed markets and emerging markets — include Lockheed Martin and CVS Health, Tesco and AstraZeneca, and FirstRand and Lenovo. 

(These are offered as representative results, not stocks I own, manage or necessarily recommend.)

On average, companies that make my top 30 lists have a return on equity of 19 per cent compared with 11 per cent overall. 

They generate lots of cash flow and dividend yields roughly twice as high as the index, with lower volatility. 

As a group they have not looked more attractively priced since the early 2000s. 

They are now trading at a 30 per cent discount to the market, a gap last seen at the tail-end of the dotcom bubble.

From such valuation lows, and using standard methods to estimate future returns, this quality class can be expected to deliver absolute annual returns of nearly 15 per cent for the next three years. 

That is well ahead of expected returns for other asset classes and, perhaps most importantly, doesn’t require taking a view on if and when the AI mania will end.

The writer is chair of Rockefeller International. His latest book is ‘What Went Wrong With Capitalism’