Perspectives

Focusing on Quality Stocks May Smooth Rough Markets

The intense equity volatility seen in recent months has been a sharp reminder that limiting losses in down markets can be just as important to long-term investment success as mak-ing money when markets are rising. In fact, it may be even more important.

It’s a lesson based on simple arithmetic: For any given percentage decline in portfolio value, investors have to achieve an even higher percentage gain just to get back to where they started. Holding losses to a minimum may be the best way to make the recovery less challenging. 

But correctly positioning a portfolio to weather the inevitable market downturns is a tough assignment. Portfolio managers must try to identify the stocks they believe have the best chance of outperforming the market when the market is in decline—without sacrificing too much upside potential when the market recovers.   T. Rowe Price research suggests that high-quality companies—those with strong balance sheets, relatively high profit margins, and relatively stable earnings—are potentially strong candidates for achieving these dual objectives. “Quality companies generally tend to do well over time,” says Sudhir Nanda, director of T. Rowe Price’s quantitative equity research group and manager of the Diversified Small- Cap Growth Fund. “But most of the benefits come in down markets. That’s when the performance gap between high quality and low quality tends to be the widest.

Quantitative Approach

T. Rowe Price analysts traditionally have used bottom-up fundamental research to identify quality compa-nies, based on an in-depth review of each firm’s market position, financial strength, senior management team, and other criteria. Portfolio managers typically rely on this research when picking stocks for their funds.However, some managers in recent years have begun supplementing this work with “quantitative” analysis, which focuses on identifying the key metrics that historically have been associated with above-average or below-average equity performance. (See chart below.)

 

 A broad universe of stocks is then screened to find companies that rank highest (or lowest) on those specific indicators. Examples of such key metrics might include:

  • Volatility statistics, such as sensi-tivity to broad market movements (also known as beta) or the vari-ability of financial performance.
  • Yield characteristics, such as dividend yield (dividends as a percentage of stock price) or payout ratio (the percentage of total earn-ings used to pay dividends).
  • Profitability measures such as return on assets (ROA) or return on equity (ROE).
  • Balance sheet metrics such as the debt-to-equity ratio.

By combining fundamental and quantitative techniques, some portfolio managers believe they can maximize the benefits of both research disciplines. “We are completely agnostic about where good investment ideas come from,” says Donald J. Peters, manager of the Tax-Efficient Equity Fund. “It could come from one of our fundamental analysts who has found a company they like or it could be a stock that ranks highly on the quantitative measures we think are most predictive.” While an idea may begin with a quantitative screen, it never simply ends there. Once a potentially promising candidate has been flagged, managers work with the firm’s funda-mental analysts to develop a complete understanding of the company, just as they would for a stock identified through bottom-up fundamental research.“That’s where our deep knowledge of companies and industries can really make a difference,” Mr. Peters notes.

Potential Shortcomings

This follow-up work is critical because one of the potential short-comings of a purely quantitative approach is that the numbers alone can tell a misleading story. A high dividend yield, for example, could indicate a company with ample cash flow—and a willingness to share it with investors—or a stock price that has been hammered down by bad news, in which case those generous dividends might not last much longer.  High return on equity—earnings as a percentage of a company’s net worth—could be a product of adding debt to a balance sheet or reflect a cyclical peak in earnings that the market hasn’t yet recognized. “The ideal situation is one where our quantitative screens tell us a stock is attractive, and we can work with our fundamental analysts to see what lies behind the numbers and whether the picture they are showing is real,” says David Giroux, manager of the Capital Appreciation Fund. “We would never invest in a stock simply because it showed up on our screens.”

Multiple Risks

Quantitative analysis isn’t only helpful for identifying potentially attractive stocks. It can also help managers understand—and try to mitigate—overall portfolio risk.Each stock has its own unique risks, such as the possibility that the company will lose market share or go out of business entirely. These stock-specific issues are the primary focus of fundamental analysis.But there also are broader risk factors that can affect larger groups of stocks or entire portfolios. These may include exposure to general market volatility, sensitivity to changes in interest rates, or the impact of the economic cycle on earnings. Managers who ignore these broader risk factors when constructing a portfolio could be taking on more risk than they realize—something that may only become apparent when markets turn downward.“If you only concentrate on individual stocks, you’re like a builder who only pays attention to the quality of each brick,” Mr. Peters says. “You may end up with a great looking bunch of bricks, but your house might not stand up very long.”

Risk Awareness

Using quantitative metrics, managers can measure the degree to which their portfolios are tilted toward or away from key risk factors, relative to their benchmarks. “To the extent you can avoid it, you never want to be exposed to risks in your portfolio that you don’t know about,” Mr. Nanda says.  But risk awareness doesn’t necessarily mean risk reduction. The same factors that can lead to portfolio underperformance could also be sources of outperformance if a manager correctly identifies a situation where the market is either underestimating or exaggerating a particular risk.“If you don’t pay attention to factor exposures, you might actually be taking less risk in your portfolio than you should,” Mr. Peters says.