Like any other asset, shares in the highest quality Australian companies typically carry a valuation premium to those at the lower end of the scale. Under certain market conditions, this premium can be substantial.
Investors then have to choose between paying significantly higher multiples for quality companies with strong balance sheets and consistent financial performance, or pay lower multiples for companies who don’t have the same reputation or track record.
At the moment, however, the spread between the highest quality companies and those outside the criteria is no longer as wide as it was a year ago. The ASX's highest quality stocks currently trade around 18 times forward price-earnings, while those at the lower end of the quality scale trade at 16.6 times forward price-earnings.
This gap of just 1.4 is not only well below the five-year moving average, it’s the lowest it has been since the market crisis of 2008. If quality stocks are market weighted, giving large-cap stocks a greater proportion in the analysis, the spread is even smaller. As a result, you can buy into Australia’s higher quality companies at a significant discount to the norm.
Relative Value Z-Score, 1988-2017, Forward PE, PB and Div Yield
While ‘quality’ has a variety of definitions, the most common include measures such as fundamental profitability, effective use of capital, strong balance sheets and relatively low volatility. The Morgan Stanley Global (ex-US) Quant framework calculates a Quality score based on an equally-weighted combination of 14 measures of financial and market performance. The highest-ranking 25% of stocks on the ASX, by these measures, were designated as quality companies for the purpose of the study.
Why Quality Companies Have Underperformed
So what are the market dynamics that have led to the shrinking gap in values? The Morgan Stanley Australian quant team, led by Steven Ye, believes that the phenomenon is largely the result of the reflation trade that has been prevalent over the past year. Driven by the belief that a recovering global economy and economic policies of the new American administration may ignite inflation, Australian portfolio managers rotated into stocks with higher earnings multiples in search of upside potential. This drove a rare year of outperformance of lower quality over higher quality stocks on the ASX.
A Timely Opportunity
Morgan Stanley’s analysts believe, however, that the reflation trade has largely run its course. This is primarily due to delays in implementing the inflationary agenda of the new US administration as well as disappointing recent retail sales figures and some contraction in the core consumer price index. They conclude that the cycle may be turning, creating a potential buying opportunity for the highest quality stocks.
While there is no particularly bad time to buy into quality companies trading at a compressed premium, the present may prove to be a particularly opportune moment. According to the Morgan Stanley Research Macro + Quant report ‘Should We Be Buying Some Quality’, market sentiment remains elevated and at risk of disappointment. While the analysts believe that underlying macro trends are positive on a global basis, domestic conditions show signs of weakness.
Higher risk conditions tend to favour higher quality stocks. Historically, these high-quality companies tend to outperform those in the bottom 25% of the rankings when interest rates are rising and equity prices are softening. These stronger companies are seen to be more resilient and benefit from a ‘flight to quality’. Lower quality companies, conversely, trade at lower multiples as their greater perceived risk demands a discount.
With domestic risks increasing and quality companies at relatively attractive prices, now might be a good time to re-examine your portfolio in order to ensure it is appropriately positioned. This convergence of valuations is a relatively unique occurrence that may present a significant investment opportunity.
Cumulative Total Return Index: 100 = Jan 1988, Market Cap Weighted Return
For more information on the Morgan Stanley Research Macro + Quant report or to discuss how the dynamics discussed in this article might apply to your investment planning, please speak with your Morgan Stanley financial adviser.