U.S. investors prefer growth over quality

Although the share prices of companies with high sales volumes have significantly outperformed quality stocks thanks to the loose monetary policies by the Fed, the market dynamics however is likely to reverse with the Fed deciding to gradually taper down its economic stimulus policy.

While picking stocks, U.S. investors prefer companies who promote “growth at a high cost” rather than those who generate consistent earnings: according to Goldman Sachs, while high-quality stocks, with strong balance sheets and stable earnings, have appreciated only 12% this year investors cannot seem to stop throwing money at companies, which have generated huge sales volumes, whose share prices have surged by 20%.

This indicates that investors prefer sales volumes over companies with stable earnings.

This lack of interest in quality stocks has whiplashed even 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,” wrote Tilson 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.”

Some asset managers are however betting that the complacent mood in the market is likely to be shaken off with the easing of the easy monetary policy and with the lowering of interest rates.

“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.”

As per O‘Hara, the willingness of investors to acquire stocks without regard to their value, the investment in quality stocks is likely to underperform. So far, markets have been supported by the U.S. Federal Reserve’s extraordinarily loose policies. But with the Fed saying it would begin reversing some of these policies gradually, by reducing its bond holdings, the skewed share prices could be straightened out.

One of several investment firms, which are beytying on this reversal is, Pacer Financial. Its “Cash Cows” ETFs buy companies with strong cash flows and healthy balance sheets.

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

This year the market has largely been led by the so-called “FANG” stocks, i.e. Facebook Inc, Amazon.com Inc, Netflix Inc and Google’s parent Alphabet Inc. Lesser known stocks, including Equinix Inc and Celgene Corp have also done very well this year.

All of them have enjoyed robust sales growth and their stock prices have climbed despite the fact that many factors disqualify, at least some of them, as quality stocks.

Case in point: Netflix has had 12 straight quarters of negative free cash flow. It has warned that it may not see a positive free cash flow “for many years” since it will continue to invest in original content, including its science-fiction drama “Stranger Things.”

Despite this, its subscriber growth has continued to exceed estimates and the stock has grown by more than 45% this year.

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

However, with the Federal Reserve’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.

In addition to this, its becoming harder for investors to asses an earnings report. For instance, tech giants, derive the bulk of their worth from services, brand value and patents – intangibles that can be hard to value.

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