When Quality Gets Cheap

As stock volatility has returned following a long lull, one of the market trends we’ve identified this year is the disproportionate selling of some of the largest and most defensive blue-chip companies. If this seems counterintuitive to you, then you’re not alone. In times of high market volatility, one would expect money to flow into those companies best able to: 1) protect their revenue and earnings streams; 2) self-fund operations; 3) pay a competitive dividend yield; and, of course, 4) avoid financial distress. But this year we really haven’t seen that flight to quality. Instead, we have seen a continued preference for those companies that offer higher growth prospects. As we all know, though, outsized growth and returns come at a price, and that price is greater risk and volatility.

In the table below we provide a list of stocks that have done exceedingly well over the past few years. On average, these stocks are up over 400% since the end of 2011. At current prices, these companies are now worth a combined $676 billion and trade at an average Price-Earnings multiple of 112x! The growth had better materialize or there could be some sizable corrections in names like these which, importantly, make up an increasing percentage of the major indices like the S&P 500.

High Growth Stocks
7a75990a-0e54-45c4-94e6-7eb0b4d4eadfPrices from intraday trading on September 16, 2015

So why are investors hoarding high-growth stocks that have already generated huge gains while selling defensive blue chips? It would seem that at this stage in the market cycle, following six years of strong market gains and on the eve of a tightening campaign by the Fed, investors would be doing quite the opposite. Well, I can think of a number of reasons.

  1. An increasing number of “investors” are operating with a trader’s mentality, content with following momentum rather than investing for the long term. Moreover, there is strong reluctance to part with the high-growth companies that have yielded tremendous investor gains during the course of this bull market (see table above). In short, they’ve fallen in love with their winners.
  2. During the initial stages of a volatile market, professional investors, both passive and active, may have opted to sell their most liquid holdings in order to meet redemptions from anxious investors.
  3. Many investors may not want to sell stocks that have done extremely well because they want to avoid sizable capital-gains taxes.
  4. The US is arguably the best-performing major economy in the world right now, and with less systemic risk thanks to the successful recapitalization of the banking system. Investors are hopeful that capital will continue to flow into the US from overseas, supporting lofty valuations for high-growth companies.
  5. Investors are willing to pay a high premium for growth because the weak global economic backdrop offers very few opportunities for strong growth
  6. And perhaps most importantly, investors have been conditioned to expect strong Fed support upon any market swoon.

In the table below we list ten companies that we would consider high-quality and defensive blue chips. These stocks have underperformed this year, and their current average P/E multiple now stands at just 15.2x the consensus estimate for calendar 2016 – right in line with the multiple for the S&P 500 (using a 2016 EPS estimate of $130.29, which could turn out to be well too high). Even more impressive, the average dividend yield on these stocks is 3.4%, which is well above the 2.2% yield for the S&P 500 and is about 50% above the yield on the 10-year Treasury note. Finally, these companies are carrying a total of $220 billion in cash on their balance sheets, representing an average of 12% of their total market capitalization. My question then is, given the market/economic backdrop, would you feel more comfortable owning this basket of stocks or the basket of stocks listed in the table above for the next five years? We think the choice is clear. Now is no time to swing for the fences.

After almost seven years of a Bull market, investors forget the pain of past plummets. They become less concerned about risk because they haven’t had to endure any significant consequence or pain for a long time. After long uptrends, investors focus on the gains they may be missing and not on the principal that they were not long ago desperate to protect. We have seen these patterns before and know that while these conditions may last a lot longer than most expect, they will change, and the greedy will suffer. Our advice is unwavering: be cautious, disciplined, dispassionate, and wise. Do your research, and think about the advice that your grandparents would offer; you’ll know exactly what you should be doing!

464ffcf2-a189-456d-94c7-2ee779731232Prices from intraday trading on September 16, 2015

The securities identified and described do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable. Upon request, Farr, Miller & Washington, LLC can provide a list of all recommendations made within the past year. If you have questions about the appropriateness of these issues for your investment strategy, please call us.

Peace,

Michael