High & Low Quality Value Stocks: A Battle

There is no doubt that value stocks can outperform growth stocks. 

When the two are compared, the evidence clearly shows that this is true. 

However, the question becomes, which will exceed the other when talking about high-quality or low-quality value stocks?

The simple answer is that high-quality value stocks rarely outperform low-quality value stocks. 

In fact, in most cases it is the lower quality value stocks that will shine when the two are compared.

The following chart shows an example of the growth of $1000 investments between 2010 – 2015. 

If you look at the graph, you can see that low-quality investments were consistently higher.

What does Quality Refer to?

The word quality can have numerous different meanings. 

When speaking regarding high-quality value stocks and low-quality value stocks; quality has a specific definition and meaning.

When used in this context, the term quality  is specifically referring the underlying company's growth and profitability.

There are investors out there that will only invest in stocks that have proven themselves. 

These investors look at the numbers and insist on investing in nothing but those that have the numbers to prove they have continuous growth, and those that consistently come with high profitability.

The problem arises in the fact that past performance does not necessarily indicate how the stock will perform in the future. 

Yes, profitability and growth are characteristics essential to any good investment; but the way they carried out in the past should not be the only two factors looked at when considering what investments to make.

Highly profitable companies that have high growth rates are too often assumed to continue their success by investors. 

However, just because a company is profitable in the past does not mean that the firm will be able to keep its head above water forever.

When deciding, which investments should be made; investors should always look toward the future. 

The past is in the past, but the future holds new possibilities, new promises, and new challenges for each and every business in the marketplace. 

Just because a company performed at the top of their game in the past few years does not necessarily mean they will be able to keep it up for the next few.

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High Quality or Low Quality?

Information can be found just about anywhere on the internet. 

The truth is that anyone can post anything, and if they set up their web page correctly, you can find information that may or may not be true. 

For this reason, the best source of information continues to come in the form of Scholarly articles.

Scholarly articles provide information in the field by professionals of the field. 

There have been several scholarly articles that have addressed the topic of how value stocks over perform when compared to the rest of the marketplace. 

Similar terms used to define value stocks across these articles have been: Out of favor and low prices ratios.

However, very few scholarly articles look at the quality as a factor when discussing quality value stocks.

Further Evidence on Investor Overreaction and Stock Market Seasonality, a paper written in 1987 by De Bondt and  Thaler, explains why it is that stocks having recently risen the most are consistently outperformed by stocks that have fallen the most end up. 

The authors used their reasoning and explained that it was natural for the “winners” to become “losers” and vice versa because of the reversals that take place in operating performance.

Simply put, a reversal that takes place in an operating performance is simply another way of stating that high-quality companies shift to low-quality businesses and vice versa. 

The value stocks that the authors used in their study had low price ratios simply because investors automatically, and inaccurately, assumed that performance by these companies would continue to decline. 

However, stock prices climbed when things went differently than expected.

It’s all Cyclical

The Most Important Thing is a book written by the billionaire Howard Marks. 

It was here that he stated that “everything is cyclical,” which has become a famous quote within the industry and something all investors should take to heart. 

He also wrote the following two rules when writing his book:

• No. 1: Most things will prove to be cyclical.
• No. 2: Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.

            Any investor, or any individual for that matter, wanting to make a profit dealing with the stock market should do the following:

• Read the above two rules as mentioned earlier by Marks.
• Read them again.
• Live by this regulation.

Understanding that everything within the stock market is cyclical allows those who are planning to invest to avoid missing the best available opportunities available to spend their money. 

The truth is that low-quality value stocks typically have low price ratios as a result of their operating results being poor; while high-quality value stocks will typically have low-cost rates as a result of passing their peak within the economic cycle.

A + B = C, or something like that

            The Magic Formula Joel Greenblatt’s high stock screen, was created to allow investors a way of locating high-quality value stocks. 

What this screen does is finds stocks that are highly profitable but have cheap price ratios. 

The system takes each stock and ranks them based on two factors.  

Those factors are the earnings yield ratio and the return on capital.

Once the calculations have taken place, the stock that has the best combination of both factors is selected for the screen. 

The magic formula is a strategy that has been consistently proven to beat the S&P 500 through vigorous testing. 

The following graph shows a comparison between the magic formula and the S&P 500:

How’s the Magic Formula Hold Up?

Wes Gray and Tobias Carlisle decided to test the Magic formula against just the return on capital factor and just the earnings yield factor and discuss the surprising results in a book titled the Quantitative Value. 

They used the period of 1974 to 2011 for part of their test. 

During this time, the found that the Magic Formula annually returned around 13.9%; compared to the nearly 10.5% returned annually by the S&P 500 during the same time.

When the study looked at the earnings yield factor; they did not filter for return on capital. 

The magic formula was shown to produce nearly a 16% return; which is 2% higher than what it is when screening for return on capital.

However, when looking at the return on capital alone; the return is right under the total return of the S&P 500. 

In fact, they are nearly equal. 

The magic number produced around 10.3% for the annual return when only looking at return on capital.

Quality Should Be Avoided

The truth is that quality should be prevented. 

However, it should not be avoided only with the intention of preventing quality itself. 

Remember that the whole point is to invest in stocks that are undervalued and have cheap price ratios.

Investors shouldn’t worry about how much quality the company has, but rather should select their stocks based on valuations. 

When investors pass over stocks that appear to have low profitability and low growth rates associated with them, they risk passing up on stocks that are on the verge of turning around.