Buying 'quality' Stocks May Be The Sweet Spot For Equities At The Moment

Does the current equity sweet spot represent the best time to invest? Perhaps it has something to do with "quality." 

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In response to the Fed's Jerome Powell's announcement that interest rates will likely rise more quickly and stay higher for longer, equity investors are scrambling for investments that will be able to weather the storm.

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There is a new style of investing that has been attracting renewed interest for investors who don't want to abandon stocks altogether and settle for two-year Treasury notes due to the safety they offer.

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“From here I would select a number of growth stocks in the market,” Peter Tchir, head of the macro strategy at Academy Securities, told me. But not just any growth stocks: “I would select companies that have stable earnings, as well as low debt.” 

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As Tchir points out, he is describing an investing style known as "quality," which can generally be defined as companies that have stable or increasing earnings, above-average returns on equity (ROE), and low debt-to-equity ratios.

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While this investing style has been around for a long time, it is based on a simple principle: if you are going through a difficult time, you need to be more selective about what you own in order to survive. On a relative basis, when earnings are declining (as they are now), companies with growing or stable profitability and low debt levels should outperform companies with declining or stable profitability in a period of decline. 

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“When you get a good day, your quality will go up more and when you get a bad day, quality will go down less,” Alec Young, chief investment strategist at MapSignals, told Trade Algo. “It’s a sweet spot where most people are hiding out.” 

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What does it mean to have a 'quality' stock?

Stocks that are screened for high quality tend to be those that are leveraged to technology and to the consumer. It usually includes big names in the technology sector, such as Microsoft, Meta, NVIDIA, Apple, and others, but it can also include more consumer-oriented names like Visa, Mastercard, Home Depot, and Costco, which are more focused on consumers.

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There have been several names in the S&P 500 that have outperformed this year, even with the S&P up about 4% in 2023:

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NVIDIA    + 59%

Meta       + 53%

Apple      + 17%

Visa         + 8%

Costco    + 6%

Microsoft  + 6%

Mastercard + 4%

Home Depot - 9%

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Among the industries which have outperformed in 2023, technology and consumer discretionary, as well as communication services - sectors that have always attracted "quality" names - have also done well.

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S&P Sector Leaders in 2023

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Technology: + 11.6%

Communication Services: + 11.9%

Consumer Discretionary: + 10.6%

S&P 500: + 3.8%

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'Quality' and its problems

Quality is an old strategy and unlike many other strategies ("Buy defensive stocks!"), it is prone to getting overbought quite easily, as it is an old strategy.

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In spite of these limitations, a saving grace of "quality" is that it is an easy strategy to explain and defend, and is also an easy strategy for people who want or need to invest in equities (such as professional investors).

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Matt Maley, the chief market strategist at Miller Tabak, explains why he believes the market is going to be upset if you own Apple stock, Microsoft stock, or other high-quality stocks in the near future. “If they do go down, they are likely to go down less than the market if they do go down. Investors who are institutional have to explain themselves to their investors in order to gain their trust.  The reason that you are holding these types of names in a tough economy makes it easier to explain why you are doing so." 

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Peter Tchir, like most professionals, has received calls from investors asking why they shouldn't just buy two-year Treasuries and ignore the stock market. Buying quality is also easier to sell to clients.

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“The amount that one should put into a five percent two-year Treasury is limited”, he said. “I’d rather bet on stocks outperforming in the next two years than on a five percent two-year Treasury. The majority of those people are going to pull their money out of bonds as soon as stocks begin to rise above that 5% return level, and by then, they won't be able to participate in the rally as much."