Do High-Quality Value Stocks Outperform Low-Quality Value Stocks?

by: Mitchell Mauer

Originally published on June 13, 2016

The evidence is clear that value stocks outperform growth stocks. The question is, do high-quality value stocks outperform low-quality value stocks? The answer is "No."

There is no indication that high-quality value stocks outperform low-quality value stocks. In fact, the opposite is often true.

What is Quality?

When we ask the question about whether high-quality value stocks outperform low-quality value stocks, we are referring to the profitability and growth of the underlying company.

Many investors insist on only investing in stocks with proven track records of consistent growth and strong profitability. Of course profitability and growth are important characteristics of good investments, but past performance is not indicative of future results.

Too often, investors assume highly profitable companies with high growth rates will continue their success into the future. This just isn't the case.

When investing, the future is what counts. The past doesn't matter. High quality last year does necessarily mean high quality next year.

High Quality vs. Low Quality

In a previous post, we listed 5 scholarly articles which clearly demonstrate the success of value investing strategies.

Each of those academic papers discuss the over performance of value stocks compared to the rest of the market. The common characteristics used to define value stocks are: out-of-favor and low prices ratios.

Quality is not taken into account in any of the papers.

For example, in the 1987 paper, Further Evidence on Investor Overreaction and Stock Market Seasonality, authors De Bondt and Thaler explain why stocks which have recently fallen the most end up outperforming stocks which have recently risen the most.

De Bondt and Thaler reasoned that the "winners" become "losers" and the "losers" become "winners" due to reversals in operating performance.

A reversal in operating performance is another way of saying that high-quality companies became low-quality companies and low-quality companies became high-quality companies.

The value stocks in the study had low price ratios because investors inaccurately expected the poor performance to continue. When things unexpectedly changed, the surprising results caused stock prices to climb.

Everything Is Cyclical

Howard Marks, the billionaire hedge fund manager and author of The Most Important Thing, has famously stated that "everything is cyclical." Here is one of his profound quotes:

There are two concepts we can hold to with confidence: - Rule No. 1: Most things will prove to be cyclical. - Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.

Anyone who wants to profit in the stock market needs to live by Marks' two rules. Knowing that everything is cyclical will allow investors to avoid missing out on the best opportunities.

More often than not, low-quality value stocks have low price ratios because of their poor operating results. On the other hand, high-quality value stocks have low price ratios because they have recently passed their peak in the economic cycle.

Since everything is cyclical, low-quality value stocks have nowhere to go but up, and high-quality value stocks still have a long ways to fall.

Magic Formula

Joel Greenblatt's famous stock screen, the Magic Formula, was created to find high-quality value stocks.

The screen finds highly profitable stocks with low price ratios by ranking every stock based on its earnings yield (price ratio) and return on capital (profitability). Whichever stocks have the best combination of earnings yield and return on capital are selected for the screen.

The Magic Formula stock screen has been vigorously tested and has proven to be a strategy that consistently beats the S&P 500 (NYSEARCA:SPY).

Interestingly, though, evidence shows that the Magic Formula would provide significantly higher returns if the return on capital filter were eliminated from the screen.

Quantitative Value

In Quantitative Value by Wes Gray and Tobias Carlisle, the authors sophisticatedly backtested the Magic Formula against just the earnings yield and just the return on capital. What they found was surprising.

When testing for the period of 1974-2011, the Magic Formula returned 13.94% annually. This is compared to the S&P 500's performance of 10.46% annually during the same period.

When investing in stocks based on earnings yield alone, without filtering for return on capital, the annual returns were 15.95%. That's 2% higher than when including return on capital.

What was the annual return when eliminating the earnings yield and only investing-based on return on capital? Only 10.37%. Just under the total return of the S&P 500.

Magic Formula Returns

Source: Tobias Carlisle. "Deep Value." (Hoboken, NJ: John Wiley & Sons, Inc.) 2014

Avoiding Quality

All that being said, quality should not be avoided just for the sake of avoiding quality. The point is to invest in undervalued stocks with low price ratios.

Select stocks based on valuations, don't worry about the quality of the company. Quality can't accurately be predicted on a consistent basis.

Investors who pass over stocks with sluggish growth rates or low profitability ratios are most likely passing up on the stocks which are about to turn around.