Quality Can Help Put the Odds in Your Favor
by Charles Rotblut | January 04, 2018
Let’s start this week’s commentary with a hypothetical scenario: A person you trust says they have two stock picks for you. Both stocks are expected to rise in price. The charts for each stock are showing similar formations and the recent news seems equally positive. You only have enough available cash to buy one of the two stocks. Which one do you choose?
Some of you will consider the valuations and opt for the less expensive stock. Others may look at the dividend. Portfolio diversification and volume would also be likely considerations. What about quality? Would you consider each stock’s underlying fundamental traits when deciding which one to buy?
I would suggest you should. While factors such as valuation, price momentum and dividends get more attention, quality matters too. Quality refers to a company’s underlying traits: Fiscal strength, profitability and the ability to return capital to shareholders. All things being equal, higher-quality companies offer more upside potential than lower-quality companies. Quality companies have more traits associated with higher returns and fewer traits associated with disappointing returns.
I personally consider a company’s quality traits because I believe in having the odds in my favor. I never know in advance how well a stock will actually perform when I buy it (nor does anybody else), but I do know lower-quality stocks have a bigger chance of falling in price. As Charles Ellis once wrote in the AAII Journal: “The secret to success is simply not making big mistakes.”
Quality should never be confused with a price increase. A stock whose price has risen since purchase may be considered to have been a good investment, but that does not make it a quality stock. Every year there is a group of stocks that rise on hype and optimism, but not much else. Every year, there are also many people who win sizeable jackpots by playing slot machines. There are far more people who lose money—a lot of it—on both.
Rather, quality refers to the underlying fundamental strength of the company. Does it generate more cash than it uses through its normal business operations? Does it efficiently turn its assets and shareholder dollars into sales and earnings? Are shareholders being rewarded with dividends and share repurchases? Is debt being kept at a reasonable level? Are earnings growing? Does management avoid using aggressive accounting techniques?
There isn’t a consensus definition for what precisely defines quality when it comes to investing, but there are commonalities in approaches. Companies should realize profits and/or positive levels of cash flow. They should be more efficient in their use of assets. Some practitioners look for reasonable levels of debt or at least decreasing levels of debt. I prefer a company to be friendly to its shareholders.
What you want to avoid are companies that are risky. It’s a simple matter of understanding the odds. Unprofitable companies, those failing to operate more efficiently and/or those that aren’t realizing positive cash flow are at greater risk of costing you money. While some of these stocks do go up in price, most don’t. So, regardless of whether you are a value investor, a growth investor, a momentum investor or a chartist, it can make a lot of sense to include some quality measures in your investing strategy.
- Piotroski: High F-Score Screen – Joseph Piotroski used a variety of criteria to separate junk companies from quality companies among deep-value stocks.
- What Works: Key New Findings on Stock Selection – James O’Shaughnessy shared the strategies he uses to identify quality and financial strength (along with value).
Optimism among individual investors jumped to its highest level in more than seven years, according to the latest AAII Sentiment Survey. Pessimism, meanwhile is at its lowest level in more than three years.
Bullish sentiment, expectations that stock prices will rise over the next six months, surged 7.1 percentage points to 59.8%. Optimism was last higher on December 23, 2010 (63.3%). The historical average is 38.5%.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, pulled back by 2.0 percentage points to 24.7%. Neutral sentiment is below its historical average of 31.0% for a fifth consecutive week.
Bearish sentiment, expectations that stock prices will fall over the next six months, fell 5.1 percentage points to 15.6%. Pessimism was last lower on November 6, 2014 (15.1%). The historical average is 30.5%.
Optimism has now risen by a cumulative 30.5 percentage points since hitting a near-term bottom of 29.3% on November 16. Over the same seven-week period, pessimism has fallen by a cumulative 19.6 percentage points.
There have only been 46 weeks with a similar or higher bullish sentiment reading recorded during the more than 30-year history of our survey. The S&P 500 index has a median six-month return of 0.5% following those previous readings, up slightly more times than it has been down.
Historically, the S&P 500 has realized below-average and below-median returns over the six- and 12-month periods following unusually high bullish sentiment readings and unusually low bearish sentiment readings. The magnitude of underperformance has been greater when optimism is unusually high than when pessimism has been unusually low. In both instances, returns have still been positive on both an average and median basis. An updated table with the historical readings can be found in my Investor Update commentary from three weeks ago.
Some individual investors are encouraged by the record highs for the major indexes, the tax cuts and/or the Federal Reserve’s decision to continue raising interest rates at a gradual pace. Other individual investors are concerned about the possibility of a pullback or a more severe drop occurring. Also affecting investor sentiment are earnings growth, economic growth, valuations and the lack of volatility. Washington politics remain at the forefront of many individual investors’ minds.
This week’s special question asked AAII members how big a percentage gain or loss the S&P 500 will realize in 2018. Nearly two out of five respondents (37%) expect the large-cap index to rise between 6% and 10%. An additional 13% of respondents predict the S&P 500 will realize a gain of between 1% and 5%, 14% expect an increase of between 11% and 15% and 7% think the index could rise by 16% or more. Tax reform was the most common reason given for the optimism, followed by economic growth. A little under 7% of respondents think the S&P 500 will end 2018 down by single digits, while 10% believe the index could incur a double-digit percentage drop. Many respondents anticipate greater volatility with a pullback occurring at some point during the year.
Here is a sampling of the responses:
- “8% gain. Continued global economic expansion and the U.S. tax cut will likely push equity prices up.”
- “Tax reform should boost the S&P 500 by 15%.”
- “Tax reform helps, but the market is already ahead of itself. I’d say 6%.”
- “I estimate a 10% increase by mid-year, but a pullback late in 2018 with further interest rate increases.”
- “5%. My guess is as good as anyone’s. Volatility will increase.”
- “It will dip in the 10% range as some of the many events that could provide a catalyst for a drop finally impact the market.”
Bullish: 59.8%, up 7.1 points
Neutral: 24.7%, down 2.0 points
Bearish: 15.6%, down 5.1 points
Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
December 28, 2017 19 Investing Resolutions for 2018
December 21, 2017 Value and Momentum Work Well Together
December 14, 2017 Optimism Has Been Low This Year, but Not Unusually So
December 7, 2017 Investors, Turn Down the Volume
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