Special Report - Why we favor high-quality stocks into year-end - Wells Fargo Investment Institute

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Why we favor high-quality stocks into year-end

Wells Fargo Investment Institute - October 22, 2020

Why we favor high-quality stocks into year-end


by Global Equity Strategy Team

Key takeaways

  • In 2020, growth-oriented stocks have dominated equity performance, and the high-quality theme has outperformed the broader markets.
  • Historically, high-quality stocks have tended to provide higher returns during the latter stages of economic expansions, recessionary periods, and periods with market volatility.

What it may mean for investors

  • We continue to emphasize high-quality asset classes and sectors, including U.S. large and mid-cap equities and the Communication Services, Consumer Discretionary, Health Care, and Information Technology sectors.

“Quality is not an act, it is a habit.” — Aristotle.

2020 has been a unique year for the equity markets. In just three quarters, we’ve experienced the end of the longest bull market in history, the shortest bear market in history, and the start of a new bull market. Historically, certain styles, themes, and sectors have shown performance leadership corresponding with specific phases of the market cycle. This year, however, growth-oriented stocks have dominated equity performance, and the high-quality theme has outperformed the broader markets.

High-quality stocks (represented by the MSCI USA Quality Index) outperformed the S&P 500 Index in 2019 and have continued to do so in 2020. The MSCI USA Quality Index also is performing better year-to-date (as of October 5, 2020) than several other styles, such as value, low volatility, and high dividend (see Chart 1). Historically, high-quality stocks have tended to provide higher returns during the latter stages of economic expansions, recessionary periods, and periods with market volatility. Low-quality, value-oriented stocks have tended to outperform in the early stages of a recovery; however, this has not happened in 2020.

Chart 1: High quality characteristics have outperformed other equity characteristics

Chart 1: High quality characteristics have outperformed other equity characteristics

Source: Wells Fargo Investment Institute, Bloomberg, as of 10/05/20. Cumulative returns are shown in the chart. For each metric, S&P 500 Index constituents are grouped into quintiles, where the top quintile is compared to the bottom quintile to calculate the factor return. Quintiles are assigned high to low, except for financial leverage, where lowest is considered highest quality. YTD=year-to-date. ROE=return on equity. EPS=earnings per share. Past performance is no guarantee of future results.

Although there is no uniform quality definition, “high quality” normally stands for fundamental characteristics that are associated with business success and stock-price growth. To determine the highest-quality equity asset classes and sectors, we focus on key characteristics such as earnings growth, profitability effectiveness, and low financial leverage:

  • Earnings growth and stability — consistent earnings growth.
  • Return on equity (ROE) — effectiveness at generating earnings relative to shareholder capital.
  • Financial leverage (Debt to EBITDA) — debt relative to available income (earnings before interest, taxes, depreciation, and amortization).

Table 1 shows a comparison of each S&P 500 Index sector based on different quality metrics (earnings growth, ROE, Debt to EBITDA).

Table 1: Sector heat map of key quality metrics  

Table 1: Sector heat map of key quality metrics

Sources: Wells Fargo Investment Institute, Bloomberg. Long-term earnings is calculated as the compound annual growth rate (CAGR) of earnings over the past 10 years, ending December 31, 2019. ROE and Debt to EBITDA as of 10/13/20. Green represents the best sector based on quality metric, yellow represents a neutral sector based on a given metric and red represents the worst sector based on a given metric. An index is not managed and not available for direct investment.

Let’s take a look at each high-quality characteristic:

  • Earnings growth and stability: The sectors with the highest earnings growth over the past 10 years are Information Technology, Health Care, Financials, and Consumer Discretionary. More recently, Telecommunications was expanded to include media and entertainment and renamed Communication Services. Historical growth is abnormally low in this sector due to a shorter history for the media and entertainment component, which has had significantly higher growth rates. We expect earnings growth to increase in the Communication Services sector over time.
  • Return on equity (ROE): This is a measure of profitably and firm efficiency. Companies in sectors with comparatively higher ROE need less capital investment to sustain their business. Information Technology, Consumer Staples, Consumer Discretionary, and Health Care historically have had the highest ROE, while Energy, Utilities, Real Estate and Financials have had the lowest.
  • Financial leverage: This can be measured by comparing a firm’s debt to its income (or earnings before interest, taxes, depreciation and amortization). Companies with low leverage typically have higher credit ratings, a lower level of financial obligations, and the ability to borrow at relatively low costs. Sectors with solid debt coverage ratios include Communication Services, Consumer Discretionary, Health Care, and Information Technology.

Throughout 2020, our tactical guidance (6 to 18 months) has favored sectors that provide exposure to higher-quality companies. We’ve found that these sectors have been more resilient during times of uncertainty, due to their low leverage, stable earnings growth, and high profitability. They also have worked well in the early stages of a recovery when there is a lack of earnings visibility and investors are trying to assess the sustainability of an economic rebound. 

Nonetheless, we realize that high-quality U.S. large-cap equities may not outperform all other asset classes indefinitely. Neither should Information Technology and other high-quality sectors outperform all the others forever. If the economic recovery gains footing, the yield curve steepens, and the U.S. dollar weakens, we would expect to see broader participation across asset classes and sectors.

Although the economy and equity markets appear to have bottomed, market risks remain in 2020 and 2021. With the potential for heightened volatility (due to COVID-19 and election policy uncertainty) in the coming months, we continue to prefer high-quality equity investments. We believe that U.S. stocks, particularly those with larger market capitalizations, in the Communication Services, Consumer Discretionary, Health Care, and Information Technology sectors, exhibit higher-quality characteristics and should be favored as we head into year-end.

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