Traditional “quality” companies are bunched in a few sectors and appear expensive—is there a more subtle definition that can uncover “hidden” quality?

Over the past few years, markets have favored a quality approach in non-U.S. developed markets. We believe that the indicators of quality that investors have sought out have been too narrowly focused on identifying companies that have a combination of high operating margins/returns, low debt and earnings “visibility,” resulting in a concentration in the Consumer Staples and Health Care sectors and valuation risk for many companies with these characteristics.

While maintaining the importance of bottom-up research into individual companies’ fundamentals, we recognize the attractiveness of quality, particularly in the current uncertain times. To identify quality companies, however, we suggest going beyond a simple focus on high margins/returns, low debt and earnings stability, to look at the efficiency with which capital and leverage are deployed and the complex interplay of these factors. We believe this can help build quality portfolios with less valuation and concentration risk.

Executive Summary

  • Quality is generally (and understandably) associated with the combination of high operating margins/returns, low debt, and stable earnings.
  • When a portfolio or equity index is oriented in favor of those characteristics, it tends to become concentrated in Consumer Staples and Healthcare stocks.
  • In addition to that concentration risk, during periods when investors seek out quality, those sectors can become expensive and subject to greater valuation risk.
  • To avoid these risks, it would be useful to identify a richer indicator of quality that meaningfully broadens the list of eligible companies outside of these two sectors.
  • We argue that understanding the interplay of margins, efficiency and leverage that underpins return on equity (RoE) can serve that purpose: this deeper analysis of RoE urges us to focus not solely on high margins, stable earnings and low debt, but on the efficiency with which capital and leverage is deployed and the complex interplay of these factors—acknowledging that some high-margin businesses are not run very efficiently.
  • When we segment the MSCI EAFE index by ranking companies by their RoE and their operating margins and stripping out those sectors where these metrics can be misleading, we find that 12% of the index exhibits relatively high RoE despite generating relatively low margins.
  • Moreover, we find that a high proportion of these “Hidden Quality” companies are not in either the Consumer Staples or the Healthcare sectors, but the Industrials and Consumer Discretionary sectors; and that by virtue of being “hidden,” they currently trade at lower valuations, on average, than the traditional quality-oriented index.

Traditional “Quality” Trades at an Unprecedented Premium

Premium/Discount of MSCI EAFE Quality Index relative to the MSCI EAFE Index, based on the trailing 12-month P/E ratio

Source: MSCI, Bloomberg. Data as of March 31, 2020. For illustrative purposes only.