The ‘Quality’ Debate in the Stock Market

Reams of articles have been written and tons of debates have happened over the past few weeks on the set of stocks popularly known as “Quality at a high price”.  While there is no watertight definition of this term, this category of stocks generally has the following attributes (not an exhaustive list though!):

  1. Long history of existence and operation, say more than 15-20 years
  2. A brand with a very high recall, and household presence (in case of B2C companies)
  3. Predictable and healthy ROCE/ROE, in turn due to:
    • Strong cash flow profile, and hence negligible/zero debt
    • Predictable margins
    • Moderate to high sales turnover ratios
  4. Shareholder friendly governance
  5. A very high valuation multiple, with regard to visible growth prospects ( that translates into an unfavourable PEG ratio)

It is the last point that invites the ire of a part of the investing community since it thinks that stock movements beyond fair multiples and into the extended zone of the overvaluation area is logically unsustainable.

So why do certain stocks defy this discipline?

In every market condition we see that certain stocks do not respect the valuation limits with respect to their growth prospects and ROCE/ ROE profile, in 2007-08, it was the infrastructure and real estate stocks, in 2017, it was the small and mid-caps, and now it is the “quality” stocks. The reason for the same is their attractiveness for dominant money flows due to one or the other reason.

Why is money continuing to flow to quality stocks?

The present market conditions reflect slow growth, uncertainty with respect to GDP revival and tight liquidity for even slightly weaker balance sheets. So the money flow is continuing to “hide” in predictable businesses with predictable earnings profile even though the growth and margins etc there may be moderate.

What is the implication of all this?

The best case scenario from here on is that we continue to see uptick in these stocks, even though at a slower pace. The worst case scenario is a time correction for some time and then a price correction.

We at East Green capital believe that selling or avoiding certain stocks just because “there could be a correction in future” would amount to pre-empting and would be tantamount to timing the market.

We have always believed that for a small investor, selling any stock with decent liquidity is a hassle free event and can be done in an instant and hence we do not gain anything by pre-empting any corrections, least of all for world class businesses with very good governance practices.

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