Studies: It’s About Value, Not Quality

“High-quality stocks” sounds like something any investor would want to own. But in a recent column for Canada’s Globe and Mail, Norman Rothery points out just how difficult it is to succeed by focusing on quality.

Rothery says that with some notable exceptions — like Warren Buffett — investors who have keyed on quality metrics have by and large been unsuccessful over the long term. “This failure is hard to explain,” he says. “Quality stocks should represent highly profitable businesses with sustainable competitive advantages. But these sterling enterprises don’t seem to produce outsized returns for investors – at least, not for those who look for quality by the numbers.”

Rothery hypothesizes that “quality” may be difficult to pin down using quantitative metrics, or that it is “so obvious that everybody can spot it. If so, quality stocks may get bid up to the point where they can no longer generate market-beating returns.” But whatever the case, he says, the numbers don’t lie. He points to the research of James O’Shaughnessy, which found that a portfolio of large U.S. stocks with exceptionally high net profit margins actually would have lagged the broader market from 1964 to 2010. Portfolios of stocks with high returns on equity or returns on assets also lagged.

But, Rothery says that looking for stocks on the other end of the spectrum isn’t a good idea. ” Mr. O’Shaughnessy’s research shows that while firms with extremely high net profit margins, ROEs and ROAs don’t generate great returns, companies that score particularly low on these measure fare much worse than the market,” he says. “High quality stocks might not make you rich, but low quality ones have a good chance of making you poor.”

What does work, Rothery says, is value investing. Many strategies that involve buying stocks that are cheap relative to their underlying fundamentals have beaten the market over the long haul.