How to separate a good quality stock from a good quality company
Investing is the antithesis of easy - picking up companies with strong balance sheets or attractively priced stocks is only one-half of the job. The combination of both criteria is where the war is really fought. In this edition of Expert Insights, Ned Bell of Bell Asset Management discusses what it takes to find those companies with the magic touch.
Ned's brought along three stocks that the team has owned before but is waiting for the right moment (i.e. a relative bottom) for them to buy back in. He says we're poised for a return to a love of quality names after three years of counterintuitive price action.
Speaking of counterintuitive price action, big tech stocks have had a huge run-up during the pandemic. But as those valuations come back to earth, Ned says he's not selling out of all big tech just yet. Why and which names will survive?
- Good companies can be overpriced stocks;
- Overbought stocks take the biggest hit when growth slows;
- Take the long view on the longevity of a franchise.
Quality stocks vs quality companies
So I think there's a big difference between a quality stock and a quality company, and the difference between those two is essentially the valuation. So you can have a brilliant company that trades on 45 times earnings, that's not a great stock. That's a good company that's too expensive, and frankly, that's just as dangerous as investing in a poor-quality company with huge earnings risk. So I think now, what we're looking for is we're finding these great companies that are getting closer to becoming really interesting stocks.
So we'll have names like MSCI, Align Technologies, Idexx Labs, these types of names that we've all owned before. They got massively overbought, but they're coming back to earth pretty quickly from the evaluation perspective, and they're not quite there yet, but they're getting close.
They're getting close to a point where after 30, 40% draw-downs, they're starting to look really attractive, so they are looking more attractive.
And I think the other point is that... What's interesting about this time around, and this is coming back to the idea about how quality will do during inflationary periods. So we did some analysis that showed that of the last 20 years, every calendar year where USCPI was north of 3%, on average, quality is a factor outperforms by 3.3%. And as of the first quarter of this year, quality actually lagged by 3.4%, which is very counterintuitive. So there's a pretty strong argument that we're poised for a big sort of rebound in terms of those quality companies being recognised by the market.
Not all big Tech are worth selling
It's taking a view on the longevity of the franchise and the valuation. So if we think about the likes of Microsoft, Alphabet and Amazon, so those are sort of the big three. While there's some moderating in growth, it's not as bad as what you've seen in a lot of other companies. So that's a big differentiating factor.
I also think the fact that we've got more of a focus on, particularly with Alphabet and Microsoft, more services businesses. So obviously in an inflationary period, more services, businesses as opposed to product businesses like Apple, is going to be a benefit.
But then when you look at the other large-cap tech names, clearly things like... Things like Facebook, we actually sold... Or Meta... We actually sold that in September of last year because of two factors.
So first one being, back then the valuation became just outrageously expensive, and we saw the growth was going to pancake down to about 4% this year. And we kind of know what happens when growth decelerates that much, and they're so well-owned. And so, and the other names that that we've sort of stayed away from or avoided are ones where, again, we didn't think the longevity of the franchise was there. So if you think about some names like Netflix, again, it's no secret that it's becoming really competitive for the streaming market. And it's very capital intensive. The spending wars between them and other players has been huge. Disney's obviously made a big push, Amazon's made a big push, and obviously two years after COVID, people are starting to get out of the house again. It was inevitable that you start to see growth slowing down.
So that's why we've stayed away from those names and focused on these others, because while there's moderating growth, we still think they can compound earnings at a pretty healthy clip going out over the next three to five years.
Learn more about Bell Asset Management
Bell Asset Management is a global equities specialist who focuses on small to mid-cap companies. Stay up to date with Ned's latest insights by following him here, or visit their website for more information.
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