Current sweet spot in equities may come from picking up 'quality' stocks

Published Wed, Mar 8 20238:39 AM EST

The current sweet spot in equities? It may be "quality." Fed Chair Jerome Powell's message that rate hikes may come faster and stay higher for longer is leaving equity investors scrambling for investments that could weather the storm. For investors who don't want to abandon stocks altogether and flee to the safety of two-year Treasury notes, one style attracting renewed interest is an old one: quality. "I would be picking growth stocks from here," Peter Tchir, head of macro strategy at Academy Securities, told me. But not just any growth stocks: "I would be picking companies that have stable earnings, and low debt." Tchir is describing an investing style known as "quality," generally construed to mean companies that have increasing or stable earnings, above-average return on equity (ROE) and low debt-to-equity ratios. That investing style has been around a long time, but it's based on a simple idea: during difficult times, you want to get more selective about what you own. When earnings are in a period of decline (as they are now), companies with increasing or stable profitability and low debt levels should outperform on a relative basis. "Quality loses less on the bad days, and goes up more on the good days," Alec Young, chief investment strategist at MapSignals told me. "It's a sweet spot and it's where most people are hiding out." What's a 'quality' stock? Stocks that screen for high quality tend to be leveraged to technology and the consumer. They usually include big tech stocks like Microsoft, Meta, NVIDIA and Apple, but can also include more consumer-focused names such as Visa, Mastercard, Home Depot and Costco. With the S & P up about 4% in 2023, most of these names have outperformed so far this year: NVIDIA + 59% Meta + 53% Apple + 17% Visa + 8% Costco + 6% Microsoft + 6% Mastercard + 4% Home Depot - 9% By industry, technology and consumer discretionary, and communication services — sectors where "quality" names often appear — have also outperformed in 2023. S & P Sector Leaders in 2023 Technology up 11.6% Communication Services up 11.9% Consumer Discretionary up 10.6% S & P 500: up 3.8% The problem with 'quality' The problem with "quality" is that it is an old strategy, and like most strategies ("buy defensive stocks!") can easily get overbought. However, the saving grace of "quality" is that for people who want or have to be in equities (like professional investors), it is an easy strategy to explain, and is easily defensible. Matt Maley, chief market strategist at Miller Tabak, explains why: "Are people really going to be mad at you for owning Apple, or Microsoft, or other high quality stocks? Even if they go down, they will likely go down less than the market. Institutional investors have to explain themselves to their investors. It's easier to explain why you are holding these type of names through a tough environment." For Peter Tchir, who like most professionals, has been inundated with calls from investors asking why they shouldn't just buy two-year Treasuries and forget about the stock market, buying quality is also an easier sell to clients. "There's a limit to how much anyone should put into a five percent 2-year Treasury," he told me. "I'd rather bet on stocks outperforming in the next two years. Most of those people are going to pull their money out of bonds as soon as stocks start rising above that 5% return level, and by then they will have missed much of the rally."