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By Robert Stammers, CFA

Editor’s note: This is the second of two conversations with Gerry Fowler, CFA, Global Head of Equity Strategy at BNP Paribas in London.

Click here to view Part 1.

CFA Institute: In your 2013 outlook, you talk about quality improvers. What are quality improvers?

Gerry Fowler, CFA: Quality improvers are those companies that are focused on improving the quality and safety of their earnings by reducing previously high balance sheet leverage and by focusing on increasing cash flows and profits.

We charted the average valuation of global companies based on their profit volatility over the past 20 years. Our research showed that there is clear market discrimination at the moment based on this measure. The most highly valued companies were the ones with the lowest profit volatility, like consumer staples and consumer discretionary companies. The lowest valuations were companies with the highest volatility in their profits. These tend to be the financials that suffered in 2003 and again in 2008. Their profit stream has been incredibly volatile. This discrimination based on “quality” wasn’t clear before 2009.

CFAI: Why does this make sense now?

GF: Ultimately, what we’re looking at here is a measure of the quality of a company’s profit stream.

Before 2009, investors discriminated very little when it came to profit volatility. No one particularly cared much for this characteristic because earnings growth was paramount. Investors didn’t care much for balance sheet strength so long as profits were growing. Then, everything got bad and cheap, down to a typical price-to-book ratio of between 1.0 and 1.5. But in the recovery, everyone has gone back to long-term investing, and is more focused on the safety of their money in their search for yield. People have decided to focus very significantly and pay a premium for stable and consistent profits. So, you can imagine that the valuation that the markets give to quality companies has increased dramatically, and all the junkier companies that don’t have particularly stable profits haven’t risen in valuation at all.

CFAI: How do you find a quality improver at a good valuation?

GF: The performance of companies like consumer staples has been amazing. Consumer staples typically only make single-digit earnings growth returns per annum, but their share-price performance has been supercharged by this valuation improvement. But last year, that kind of went sideways because that valuation disparity based on quality reached too high a level. There are only so many people who are willing to pay more than 16 times the earnings for a consumer staples company when they can be buying, for example, a materials company on a forward earnings ratio of under 9 times. That disparity became too large, and the stock price performance of the highest quality companies has started to go sideways.

I see an evolution of this theme here. I don’t think deep value is going to return right now. But some concept of value is going to come into the system. Those companies that are slightly cheaper and show that they are progressing towards higher quality not only will have better profits in 2013 because they’re improving their earnings, but also the market will re-rate them and give them a higher valuation. So, the stock price performance of those companies will end up being the best, in our view.

CFAI: Which sectors look good?

GF: An example is global developed-market materials companies, like some of the big U.S., Canadian, European, and Australian miners (metals and mining). For quite a long time now, especially in the last three years, these materials companies have been reducing the leverage on their balance sheets. That’s great. That’s improving the quality of their balance sheets.

Also, the 2013 earnings growth estimates for materials companies are about +20% because these companies are reducing their exploration and capex spending to improve their cash flow and earnings.

Rio Tinto (NYSE:RIO), as an example, reduced its debt-to-assets in 2009 from about 40% or 45% down to about 18%. So, it has halved its leverage in the last three years to improve the quality of its balance sheet. But in addition to that, the materials companies are focusing on improving the quality of their profits and the quality of their cash flows, and they’re doing that by cancelling and postponing big capex projects.

They’re no longer building massive mines. I think Rio said late last year that it will save £5 billion over the next couple of years by postponing capex projects. By not spending money on capex, so long as they’re still making money from their existing mines, even if growth is slower, they’re able to return more to shareholders, either through dividends, buybacks, or just simply by letting it sit on the balance sheet as cash while the company becomes worth more and more.

CFAI: Any others?

GF: There are certainly some healthcare companies that could be quality improvers in 2013 as well. Perhaps a few energy companies and even maybe some financials can show they have improved their quality.

Some of the large global healthcare companies know they’ve got patents expiring and a workforce or a sales distribution network that is far too large. These companies have been laying off people to reduce their costs, and more are efficiently using technology as part of their quality improvement efforts.

CFAI: What’s the downside?

GF: From here on out, we expect valuations to be less of a driver on the upside for the highest quality companies. They are already fairly expensive now. Therefore, investors need to search lower down the quality scale to find a little bit more cyclicality and a little more value. The risk is that monetary and fiscal support for markets is still critical given underlying economics remain fragile. The growing optimism and risk appetite of investors may be shaken if either of these market supports is withdrawn before a recovery in private demand emerges.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Source: Positioning Yourself For Higher Valuations With Quality Improvers