When the market heats up, focus on quality

If you know that the stock market will crash tomorrow, you should sell your stocks. The problem is that no one knows when that crash will happen and how long it will really last.

There’s a saying that we like to quote from time to time: there are two types of investors – those who think that they can reliably predict when the market will crash, and those who understand that they cannot predict the market, at least not repeatedly.

The Sifter Fund belongs in that latter category.

We don’t have a crystal ball, and we certainly wouldn’t want one.

If you’re certain that the stock market is due for a correction and that the economic tides will soon turn against you, but you’re not willing to roll the dice by exiting the market, you can shape your portfolio to suit your principles.

When the market is at an all-time high, it pays to focus on quality.

Based on historical figures, top-quality companies have been better at maintaining the value of their shares during stock market downturns than the average company.

In fact, a quality-oriented investment strategy is at its best in tumultuous market conditions.

T. Rowe Price divided five hundred large European companies into ten brackets on the basis of specific numerical, quality-oriented criteria and monitored the performance of these portfolios from the beginning of 1996 up to the end of September 2012. The companies that were evaluated as the most high-quality generated the best returns, the second-best companies placed second, and so on.

The best companies provided the best excess returns whenever the stock market took a nosedive.

This also seems to have happened during the market downturn last spring. Sifter’s portfolio of 30 quality companies strengthened and has provided about 6% excess return since the beginning of the year (compared to the benchmark index, MSCI ACWI).

There are several reasons why top-quality companies are able to generate relative excess returns during economic downturns.

The most important factor is that their high-quality business models provide results no matter the market, and these companies are also able to withstand downturns better than the average company.

In fact, one of the most important criteria of the Sifter Fund is having a stable profit model.

A company’s cyclical stability can be the result of having a product or service whose demand does not fluctuate with market cycles.

Traditionally, this has been the domain of strongly branded grocery corporations. Today, several ICT service providers can also be included in this bracket.

For example, the Sifter Fund’s portfolio has long included VeriSign Inc, an American company that manages the .com and .net domain names used by corporations around the world.

After all, few companies are willing to shutter their websites, even in a recession.

In addition, top-quality companies possess competitive advantages that help exclude them from the type of price competition that usually impacts any overly crowded sectors of the market whenever supply exceeds demand.

Since the return on invested capital for top-quality companies is so high, they can generate good results even when their profitability takes a hit. Any low-profit companies that are subjected to the same conditions are likely to go into the red.

High return on capital figures – e.g. ROIC and ROE – are the keys to identifying a top-quality company, especially when it has very little debt.

Top-quality companies are also the relative winners of a bear market because investors value stability in times of hardship.

Since top-quality companies operate in ways that are easier to predict, people are more likely to invest in them.

Even those investors who seek extra earnings potential from fledgling or harder-to-predict companies in a bull market will focus on quality when the market takes a turn for the worse.

Financially stable companies with little to no debt will not need fret if it suddenly becomes harder to tap into additional financing. On the contrary, they can reap the benefits provided by their financial stability while their competitors run headfirst into trouble.

When the times get tough, a market leader can solidify its position even further.

One key reason to invest in quality is peace of mind.

Even if the share price of an exceptional company were to fall rapidly, you can still feel secure in the knowledge that a great company will always generate returns to its owners.

When the market calms down, the share prices of great companies usually rise the fastest. The greatest losses are made when an investor forgets what they know and loses their nerve.

Investing in top-quality companies generated an annual return of +31.3% to the Sifter Fund in 2019.

Santeri Korpinen
CEO, Sifter Capital Oy

This article was first published in Finnish on 10 February 2020 on the website of Arvopaperi, Finland’s premier financial publication.

Disclaimer. The contents of this page do not constitute investment advice or purchase recommendations for stocks. This page describes our opinions on the companies we have invested in or whose shares we have sold. The past performance of the fund is not a guarantee of future results.
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