Enduring qualities of superior stocks

Companies with robust balance sheets and strong brands yield the best results in the long term, despite many investors having scooped spectacular returns from low-quality stocks last year.

KATRINA MEAD is a member of the portfolio management team of MFS Meridian US Value fund

Investors who owned only the cheapest stocks in the universe as measured by price/earnings multiples (P/E), regardless of their quality, over the same time-frame, would have experienced more dramatic cumulative excess returns compared with the same universe of just over 500%. This demonstrates that valuation is an important driver of long-term stock price performance.

However, the most dramatic relative performance advantage would have occurred at the intersection of these two variables of high-quality and low valuation. Investors who owned the highest quality and most cheaply valued companies would have experienced cumulative excess returns of nearly 950% over that time-frame. The consistency of the relative outperformance of this group over rolling five-year and 10-year periods is impressive, as seen in the accompanying chart.

Our analysis also demonstrated the persistency of the quality characteristics of companies. Companies in either the highest or the lowest quality quintiles, as measured by return on invested capital (ROIC), were the most likely to sustain those levels over time. In other words, companies – even those in highly cyclical or challenging industries – are less likely to fade in terms of performance as often or as quickly as market observers commonly think. This is consistent with some analysts’ experience in following some of the global brand leaders in MFS Meridian portfolios, which have sustained above-average returns on capital for many years.

However, the dearth of companies in the analysis that migrated over time from lower to higher ROIC levels underscore the disappointment commonly felt by ­optimistic investors who forecast a turnaround that does not materialise.

The fundamental lesson learned is that companies with high levels of return on invested capital are more likely to sustain this positive attribute over time. Therefore, it is better to focus our efforts on identifying and owning shares in those companies rather than trying to identify the rare “home run” that results from finding a company that moves from third-rate to first-rate. Those companies that do emerge do not compensate for the high proportion of those who do not.

In general, many investors tend to be short-term focused and underestimate the impact of compounding above-average returns over time. A global team of seasoned analysts working collaboratively to uncover those opportunities when they are selling at reasonable valuations can yield superior long-term returns for investors.