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May 2019

You Need to Understand Some Key Latent Risks in “Quality” Stocks

By Insights - Institutional investor

Quality investing using Return on Equity (ROE) has been a successful strategy in recent years, but requires careful consideration of the risks, which can differ substantially depending on the stock or the industry. In industries with barriers to competition, we believe it to be embedded with latent risk that often is not accurately quantified by measuring the volatility of the share price.

In competitive industries, ROEs mean revert.

In a competitive industry, free market forces drive ROEs to mean revert.

Projects flock to adequately supplied industries with a reasonable ROE. This additional capacity relative to demand will in turn create competitive tension, decrease pricing power, and the return on equity will fall.

Conversely projects are cancelled in adequately supplied industries with a low ROE. This reduced capacity relative to demand will weaken competition for existing participants, increase their pricing power, and the return on equity will rise.

Competitive Barriers are a Trending Force.

Barriers come in many different shapes; regulatory, patent protection, data sample quality in social media, or access to specialised skills amongst them.

Barriers lead to upward trending ROEs, because any positive incremental demand will lead to increased pricing power when the supply does not change – which may well be the case, if there are few participants offering a solution.

Often therefore, these upwards trends in ROEs can be multi-year affairs – driven by increased demand for automation, regulation (e.g. tax digitisation in the UK) or just simply population growth.

Cost of Equity Matters.

When discussing the dynamics of ROE, obviously the cost at which equity can be deployed matters hugely. In fact, we would revise our earlier statement – ROE minus the cost of equity are mean reverting in a competitive market.

The cost of equity is neither static through time nor uniform across the index. It varies as risk perceptions change, as the market in aggregate becomes progressively more or less optimistic on prospects for the business sector, the industry, the economy.

In the cross-section of companies across the index there can be large variability too. Even though base rates are low, we see access to equity capital vary significantly – at times the distribution has been skewed towards stocks that have had the right combination of characteristics, for instance, companies with stable cashflows, low financial leverage, liquid stocks or stocks with defensive earnings.

Further for the companies with cheap access to equity are able to easily fund acquisitions, or buy-back stock, to further grow earnings. This self-reinforcing loop, from the market, towards stocks with High ROEs and competitive barriers, can exacerbate the momentum of high ROE names. This is the environment prevalent in the period 2011-2013 in particular.

Risks for High ROE Stocks Going Forwards

The greatest risks to these high ROE stocks with competitive barriers going forward is a reversal of interest rates, especially a Fed policy error. This seems unlikely at this stage, given stubbornly low inflation in the US and no rate rising pressure in many markets worldwide. Often these risks are not easily measured with the historical volatility of the stock, or any clear fundamental signal, but they can be brutal sell-offs.

As an example, in Q4 2018, even without too much of a change in the outlook for the company, CSL fell nearly 25% between the 31-August and the 25-October, as 10-year US treasury yields climbed from 2.86% to 3.12%.

In Conclusion

This note describes the nature of some of the broad risks associated with high ROE stocks. We believe that the nature of these risks differ substantially depending upon the competition structure of the particular industry.

In highly competitive industries, we see risks of mean-reversion in ROE as new entrants increase investment in capacity.

In industries with competitive barriers, we see a reversal in global interest rates, particularly the US, as a catalyst for derailment in the upwards momentum in these stocks. These risks are not easily quantified from historical share price volatility so may go under-appreciated.

In positioning portfolios, we need to ensure we think about these risks, even in periods where interest rates look to be “lower for longer”.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.