In Today's Market, Quality Companies Are Cheap (HD, INTC, JNJ, MSFT, PFE, WMT)

One of the interesting things about the market today is that despite relatively high valuations across asset classes globally, within the US market many of the biggest and the best companies are just not expensive relative to the rest of the market and relative to their own historical valuations.

Examples include: Microsoft (MSFT), Intel (INTC), Wal-Mart (WMT), Pfizer (PFE), Johnson & Johnson (JNJ), and Home Depot (HD). These are among the best run companies on the planet and while none are dirt cheap and all certainly face multiple challenges, it’s hard to argue that any are overpriced.

More interestingly, it seems that there is some data to support the notion that today’s valuations assign a premium to lower quality businesses rather than higher quality ones. As support, take a look at Morningstar’s Market Valuation Graph.

Morningstar covers thousands of companies and ranks them by “size of moat” (how defensible their business is) and “business risk.” You can write a PhD thesis dissecting the value of Morningstar’s rankings, but let’s assume that the company’s analysts on the whole do a decent job of divvying up their coverage universe into three moat rankings (wide, narrow, none) and three business risk rankings (below average, average, above average), and valuing the companies.

The Market Valuation Graph shows how over or undervalued different sections of the market are. A rating of 1.00 indicates fair value. Ratings above 1.00 indicate overvaluation and below 1.00 undervaluation relative to fair value.

Here are how the three buckets of business moats rate currently:

* Wide Moat 0.91
* Narrow Moat 0.98
* No Moat 1.11

The most straightforward interpretation of this data is that the better a business's moat is, the cheaper its price is.

The current business risk rankings indicate a similar trend:

* Below Average Risk 0.92
* Average Risk 1.00
* Above Average Risk 1.07

So the riskier the business, the higher the price.

We’re sure that rational arguments can be made for all sorts of interpretations of these statistics, but the most obvious conclusion to us is that in today’s market, business quality and valuation are inversely related. Put differently, quality is cheap and garbage is expensive.

How can one act on this information? We’re not macro investors so we won’t go out and buy an ETF representing our views, but we will continue sifting through the high quality bin for individual names that make sense to us.

And if you happen to be an investment banker, maybe by convincing your clients to destroy their moats and pursue riskier business models they’ll be worthy of a higher valuation.