Finding Quality in Value Stocks

Typical Growth portfolios carry a strong weighting of large and highly profitable companies with a low level of debt. In this context, the concept of ‘GRANOLAS’ stocks is often used. What might sound like a cereal bar at first is – according to Goldman Sachs – a synonym for the largest European public companies by market capitalisation: GlaxoSmithKline, Roche, ASML, Nestlé, Novartis, Novo Nordisk, L’Oréal, LVMH, AstraZeneca, SAP and Sanofi. Apart from their strong benchmark weighting, these stocks also offer high profitability, stable long-term growth, and a low level of debt. However, a closer look at the different multiples reveals a decisive disadvantage: on average, GRANOLAS are traded at extremely ambitious multiples. Based on current earnings, their average P/E ratio is around 35, and thus significantly higher than the European market average of 19. Even if we take future earnings into account, the P/E ratio drops to 18, while pricing for the market as a whole is at a moderate multiple of 12. Yet a halving of the P/E ratio also means that the market expects earnings to double. Whether this will be possible is – at the very least – questionable, given the depth of the economic downturn caused by the COVID-19 pandemic.

Active weighting relative to the benchmark

High quality – at a reasonable price

In accordance with our investment philosophy, these expensive Growth stocks are generally underweighted in the Quoniam equity portfolios. Our quantitative share selection process considers a variety of factors at the same time. In particular, the Value and Quality factors are simultaneously included in our forecast – this means that a particular share should always feature both of these characteristics in order to qualify for the portfolio.

Figure 1 shows the active weighting relative to the benchmark in the European Dynamic strategy as at 30 April 2020. To this end, the investment universe was divided into nine sub-portfolios using the Quoniam factor signals for Value and Quality. In the portfolio, this leads to a distinct weighting in favour of those stocks that are both of above-average quality and attractively valued. We are approximately 15% overweight in these issues. Some low-priced stocks with medium quality and a few high-quality and expensive stocks are also overweighted. We are underweight in all low-quality stocks, and in almost all expensive stocks.

Squaring the circle in practice

Figure 2 shows examples of different overweighted stocks in the European Dynamic strategy, confirming these characteristics. Automobiles and household appliances are cyclical consumer issues. Peugeot is a classic Value share, which we bought primarily because of its very attractive valuation. Its P/E ratio over various periods is well below 5x and the price-book value is clearly below 1, which in turn offers material discounts compared to the overall market. At the same time, return on equity at just under 18% and gearing at 17% also remain more attractive than the general market (13% and 28%, respectively). In this case, the extremely favourable valuation is therefore not offset by below-average quality.

Electrolux shows a significantly higher profitability compared to the general market. At 24%, its return on equity is almost three times as high as what the MSCI Europe has to offer (8.6%), and its gearing of approximately 14% is very attractive as well. Here, too, the valuation is still favourable, as shown by the EV/EBIT of 12.6 and the high dividend yield of 5.4%. Yet not all valuation indicators show extreme cheapness. In this respect, Electrolux is rather a quality stock with an attractive price.

All things considered, we aim to ‘square the circle’ – that means our goal is a balanced mix of the Value and Quality factors. Thus, the Quoniam portfolio offers an attractive valuation amid above-average quality of the overweighted companies, and avoids overpriced quality as well as ‘value traps’, i.e. companies that are cheap for a good reason.