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When it comes to U.S. stocks, growth trumps quality



Traders
work on the floor of the NYSE in New York

Thomson Reuters

By Trevor Hunnicutt

NEW YORK (Reuters) – U.S. investors are not rewarding companies
for generating good earnings consistently, opting instead for a
stockpicking strategy that might be called “growth at a high
cost.”

High-quality stocks selected for their strong balance sheets and
stable earnings have appreciated just 12 percent this year,
according to Goldman Sachs Group Inc , while the broader S&P
500 <.spx> benchmark index has returned 13.8
percent.</.spx>

But investors cannot seem to stop throwing money at companies
improving their sales fastest: a group of such equities tracked
by Goldman Sachs has surged 20 percent. Put another way,
discriminating investors who have chosen companies with stable
earnings prospects are being punished.

This lagging interest in quality stocks has even whipsawed
well-known fund managers; Whitney Tilson said this week he was
shutting down his Kase Capital Management LLC hedge fund.

“Historically, I have invested in high-quality, safe stocks at
good prices as well as lower-quality ones at distressed prices,”
Tilson wrote to investors.

“Given the high prices and complacency that currently prevail in
the market, however, my favorite safe stocks (like Berkshire
Hathaway and Mondelez ) don’t feel cheap, and my favorite cheap
stocks (like Hertz and Spirit Airlines ) don’t feel safe. Hence,
my decision to shut down.”

Yet some managers are betting that complacent markets could be
shaken from their zombie-like slumber as easy monetary policy and
its backdrop of lower interest rates comes to an end.

“In an environment like we’re in now – where no one really cares
what things are worth – you may underperform, but over time
reality will set in,” said Sean O’Hara, director at Pacer
Financial Inc. “It always does.”

REVERSAL OF STIMULUS

O’Hara said quality investments underperform when investors are
willing to buy stocks without regard to their value, and that
markets have been supported by the U.S. Federal Reserve’s
extraordinarily loose policies.

Earlier this month, the Fed, as expected, said it would begin to
reverse some of those policies by gradually reducing its bond
holdings.

Pacer Financial is one of a several investment firms betting that
quality will matter again. Its “Cash Cows” ETFs buy companies
with strong cash flows and healthy balance sheets.

Goldman Sachs’ global investment research unit included companies
such as retailer Ross Stores Inc , pharmacist CVS Health Corp and
oil driller Schlumberger NV in its high-quality group earlier
this year.

Yet these companies have mostly not been star performers.

The market has been led by so-called “FANG” stocks – like
Facebook Inc , Amazon.com Inc , Netflix Inc and Google parent
Alphabet Inc – and a small winner’s circle of lesser-known names
like Celgene Corp and Equinix Inc .

These companies have all enjoyed robust sales growth in a U.S.
economy that’s below its boiling point, even as many factors
disqualify some of them as quality stocks. Netflix has had 12
straight quarters of negative free cash flow, and the company
warned it may not see positive free cash flow “for many years” as
it invests in original content like the science-fiction drama
“Stranger Things.”

Still, its subscriber growth continues to exceed estimates, and
the stock has rocketed more than 45 percent this year.

LUXURY OF GROWTH

Investors are paying a premium for the luxury of revenue growth:
$24 for every dollar of earnings per share anticipated over the
next 12 months, compared to $20 for quality names and $13 for
high adjusted free-cash-flow yield equities, according to Goldman
Sachs data.

Raffaele Savi, a portfolio manager for BlackRock Inc’s $647
million Global Long/Short Equity Fund , said strong revenue
growth is “more rare than at many points in the past,” given U.S.
gross domestic product growth averaging around 2 percent
annually. The fund’s recent performance commentary said investors
have been shunning company fundamentals.

With the Fed’s interest-rate hiking cycle taking hold, investors
are bracing for market dynamics to change.

“When you see these huge headlines on big investors and hedge
funds throwing in the towel because they can’t make sense of the
market, that is a sign that things are about to turn,” said
Guggenheim Partners LLC global chief investment officer Scott
Minerd.

Part of the reason quality does not work as well as it once did
may be that more assets follow “quantitative” funds that rely on
the same statistics measuring quality, said Brian Hayes, equity
strategist at Morgan Stanley & Co LLC .

Plus, it’s harder for investors to assess what an earnings report
is saying. Technology giants, for instance, derive more of their
worth these days from services, patents and brand value,
intangibles that can be hard to value.

(Editing by Jennifer Ablan and Bernadette Baum)

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