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

U.S. investors are not rewarding companies for generating good earnings consistently, opting instead for a stock-picking 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% this year, according to Goldman Sachs Group Inc., while the broader S&P 500 benchmark index has returned 13.8%.

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%.

Wise investors punished

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 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,” Mr. Tilson wrote to investors.

“Given the high prices and complacency that currently prevail in the market, however, my favourite safe stocks (like Berkshire Hathaway and Mondelez) don’t feel cheap, and my favourite 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.

‘Reality check’

“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, Pacer Financial Inc. “It always does.”

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

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.

These firms have all enjoyed robust sales growth in an economy that’s below its boiling point. 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.

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

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