High quality stocks work long-term and also in 2020

Our general recommendation is for long-term investors to be half-exposed to the equity market and keep the remaining part of the portfolio in cash or short-term government bonds. A bit of gold would also be a good additional diversifier. The next question is then what equities investors should invest in while they wait for a setback. Long-term quality stocks have outperformed the general market since 1981 by a large margin, and in general Warren Buffett also changed his approach over time from deep value stocks to high-quality stocks with a understandable and predictable business moat. The biggest index provider in the world, MSCI Inc., uses three fundamental ratios as the components for selecting high-quality stocks: return on equity, debt-to-equity and earnings variability.

We prefer return on invested capital (ROIC) over return on equity as it better reflects the return on the total capital invested. Return on equity can be inflated by using a lot of debt; think financials in the years leading up to 2008. Debt-to-equity is not our preferred metric either as we would prefer net-debt-to-assets to avoid a metric with a potential negative denominator, which could happen due to a lot of share buybacks. One case is Rockwell Automation, where its debt-to-equity ratio is a mammoth 558% due to share buybacks. But if you look at its net-debt-to-assets then the ratio is only 20%, which is still high for a quality company but easily manageable through its cash flow generation. Earnings variability is a good measure unless a big shift in the competitive landscape happens, because then you will be behind the curve as a function of your lookback window to compute this earnings variability; it’s probably better just to analyse the industry outlook and apply that human judgement.

Our preferred method is to look at ROIC/WACC, where WACC is the weighted average cost of capital. If this spread is above one then the company is creating shareholder value. Secondly a good net-debt-to-assets position combined with a strong business moat in an industry with a positive outlook are the next variables we look at. Combining these variables without regard to valuation, we filter the US and European large cap segment top to 25 high-quality stocks that could do well even during a deep recession due to COVID-19. These 25 stocks have delivered on average 10% return this year in local currencies, thus outperforming the overall equity market. However, please be aware that this is not an indication of future performance.

Source: Bloomberg and Saxo Group

* YTD in % is the total return year-to-date in local currency