The Quality Conundrum

Last week I spent some more time screening through possible buy ideas. A sector that has been roughed up caught my attention – the asset managers. Given my view on equity valuations, combined with the fact that most asset managers are relative return investors, I believe the industry could lose considerable assets and revenues once the current cycle ends. And of course there remains the ongoing threat of passive investing. Nevertheless, several equities within the group seem to be pricing in some pretty difficult times, so I decided to take a closer look.

One of the asset managers I reviewed has an investment process that appeals to me. Specifically, this particular manager states it invests “with a quality bias” and may lag in up markets and outperform in down markets. I like this concept, especially at this stage of the market cycle. In fact, if I was selecting an asset manager today, I’d be looking for managers that have historically outperformed in bear markets and have underperformed over the past 3-5 years. Interested to learn more, I opened the hood and reviewed the firm’s 13-F. And yes, there it was, a portfolio “with a quality bias”.

As I sorted through their holdings, I bumped into many high-quality names that are also on my possible buy list. There was no doubt in my mind that these were good businesses. But were they selling at good prices? Many of the businesses I was familiar with were mature companies with low-to-moderate growth rates. However, their valuations implied above-average, and in my opinion, unrealistic future growth rates. As such, while I concluded they were in fact good businesses, I did not believe they were selling at good prices.

It’s no secret high-quality is preferred over low-quality for investors seeking safety near the end of a market cycle. It’s a go-to play in the portfolio manager handbook (page 37 paragraph 4). The thinking goes that when the market and economy are in decline, high-quality businesses – particularly those with good balance sheets – will outperform their lower quality peers. In theory, higher quality companies will have steadier cash flows and will be impacted less by declining demand, faltering liquidity, and widening credit spreads.

The 2000-2002 bear market is a good example. In addition to avoiding technology, owning quality and strong balance sheets paid off handsomely during this period. In fact, it worked so well many high-quality value stocks generated positive absolute returns in what was a relatively nasty bear market (S&P 500 declined -47% from its peak in March 2000 to its low in October 2002).

High-quality protects capital best when it’s being ignored and valuations are attractive. Such an environment often occurs near the end of a market and economic cycle, when trend-following investors are favoring lower quality or highly cyclical companies (think energy in the summer of 2008). And that’s the glaring difference between today and past periods, such as 2000-2002. Currently, quality is not being ignored and valuations are not attractive, in my opinion.

Lancaster Colony (LANC) is a good example of a high-quality business that was ignored during the late stages of past cycles, but is cherished today. Founded in 1961, Lancaster Colony is a manufacturer and marketer of specialty food products. When I think of their business, I think of salad dressing, dinner rolls, and croutons. It’s a boring but high-quality business with a strong balance sheet and consistent cash flows.

Before the bear market in 2000 began, Lancaster Colony was trading at 13x earnings and was priced as a value stock. Given its relatively low valuation, Lancaster Colony’s stock provided investors with a healthy margin of safety heading into the bear market of 2000-2002. In fact, its stock was so attractively priced, it actually increased 58% while the Russell 2000 declined -44% from the 2000 peak to 2002 trough! During this period, owning Lancaster Colony and quality worked magnificently.

Currently trading at 35x earnings, I no longer consider Lancaster Colony a value stock. And that of course is the big difference between high-quality this cycle and when quality worked in the past – valuation! In the case of Lancaster Colony, the difference between 13x and 35x earnings is considerable. From a risk management perspective, it’s the difference between swimming with a life jacket and a bag of cement.

While it remains up for debate, let’s assume the end of the current market cycle is approaching. Let’s also assume most investors believe high-quality companies outperform during the end of market cycles and are positioned accordingly. If these assumptions are true, is it possible that investors seeking safety in quality are actually piling into overcrowded positions with elevated risk?

Based on the large dispersion in valuations between high-quality businesses and lower quality businesses with well-known risks, I believe investors may be relying too heavily on the “what worked last cycle” playbook. Instead of flocking into high-quality, what if buying equities that are already in bear markets (preferably with strong balance sheets) provides better downside protection? And let’s also not forget, investors have the choice of not owning high or low quality equities and waiting out the end of the current cycle in the comfort of T-bills (3-month currently yielding 2.42%)! Of course that’s if you have that option. Many asset managers focused on relative returns and with fully-invested mandates do not.