Uncertainty over the global economy and declining bond yields has helped drive strong returns from ‘quality’ stocks in areas like staples over the last decade. It now seems that for some of these companies, the days of strong revenue growth and margin expansion may be behind them. Notably, recent history also shows that investing in high return businesses is often not as rewarding as finding companies that are improving their returns.
One of the major features of the post-financial crisis landscape across global equity markets has been the strong performance of ‘quality’ companies, as defined by return on capital or margins in the business.
Why has ‘quality’ done so well? Partly because of investor uncertainty about the global economy – when we worry about demand weakness in the economy we would rather have companies that have high levels of profitability and relatively low sensitivity of revenues to the economic cycle. But ‘quality’ was also helped by the long running decline in bond yields which, for now at least, appears to have stopped.
If we think about the types of company that could epitomise ‘quality’, we naturally converge on consumer staples or FMCG companies. Most of these have enjoyed nearly 20 years of expanding profit margins and have traded at progressively higher multiples of earnings.
Since 1999 Nestle, for example, has roughly doubled net margins. The most extreme examples would also include tobacco companies like British American Tobacco. However, after a very strong run since the start of 2000, it has fallen significantly over the last 12 months at a time when many other staples companies have also struggled.
It seems that for many of these companies, the days of strong revenue growth and margin expansion may be behind them. The clear message is that investing in good quality (high return) businesses is nowhere near as rewarding as finding companies that are improving their returns.
In a fascinating study a few years ago, Credit Suisse analysed global data from 2003 to 2012 looking at the best and worst performing companies by CFROI (cashflow return on invested capital). This found that over that relatively turbulent period the top 20% of companies by CFROI returns at the start of the period produced lower returns than the middle and lower slices.
Quite surprisingly, companies that started in the top fifth by CFROI and ended in the top fifth also produced a slightly lower return than middle profitability companies that ended in the middle. The notion being that sometimes investors pay too much for quality.