By Eric Bush, CFA, Gavekal Capital Blog
"Quality" is one of the those terms in finance that if you ask three different investors to define, you get four different answers. Generally, however, companies with higher profitability, lower debt, and higher sales growth are considered to be higher-quality. Lower-quality companies tend to have the opposite characteristics. Over the past three months, investors in developed market equities have been bidding up lower-quality stocks.
The fundamental factor that has had the highest r-squared value to the stock market over the past three months is return on equity (ROE). The top three deciles of stocks with the highest ROE have only returned about 0.4% (in USD), while the the bottom three deciles of stocks with the lowest ROE have returned 4.7%. Similarly, stocks with the lowest sales growth have outperformed stocks with the highest sales growth by nearly 8% in just three months. Stocks with the lowest sales growth have returned 7%, while stocks with the highest sales growth have returned -0.9%. Lastly, stocks with the highest net debt as a % of total capitalization have compete trounced all other stocks during this period as well. The decile of stocks that have the most debt have returned 9% over the past three months, while the average return for the other nine deciles is just 1.3% and stocks with the least amount of debt have fallen by -1.4%. All in all, the rally in developed market equities over last three months has clearly been led by stocks with the shakiest fundamentals.