The Extraordinary Opportunities in Some of the Market’s Highest Quality Stocks

In April last year, KCR penned What is Accounting Quality and Why it Matters. The work discussed the abysmal state of financial reporting and used our earnings quality score to demonstrate that high-quality firms trounced low-quality firms’ performance. Our earnings quality score measures firm quality based on items like profitability, return on capital, and the integrity of a company’s financial reports.

In an efficient market, stocks that are more profitable and efficiently run would sport higher valuations than unprofitable companies with shoddy reporting. Yet as our work (and behavioral finance) has shown, inefficient markets are the rule, not the exception. In the first quarter KCR watched low-quality shares soar while the prices of many high-quality stocks declined. Is the market offering investors a compelling entry point?

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Since 2010, KCR’s monthly equity ranking tools have systematically created concentrated, low-turnover model portfolios of high-quality stocks trading at discounts to fair value (“long portfolios”) and portfolios of low-quality stocks trading at unjustified valuations (“short portfolios”). Using our long and short portfolios built using our US Large Cap model, this paper will show that:

  1. Value spreads between our long and short portfolios are coming off the highest levels ever recorded
  2. Earnings quality spreads are just shy of the record observed at the height of the dot.com bubble
  3. These spreads provide evidence that mean reversion from the bubble peak in December 2021 has just begun

Let’s rephrase these opportunities in colloquial language:

  1. Some of the most profitable and well-run companies are also among the least expensive
  2. Some of the most expensive stocks in the market are also unprofitable, poorly run, and sport lax accounting
  3. For long-only investors and short-sellers alike, the opportunity set appears remarkable to KCR

What You Pay:

The chart below shows the valuation score of our US Large Cap longs minus the valuation score of our shorts. After peaking in December 2021, value spreads between our long and short model portfolios have just now hit the levels seen at the peak of the dot.com bubble.

S&P500 Large Cap Long/Short Spread: KCR Valuation Score

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What You Get: The chart below shows the spread in Earnings Quality between our long and short model portfolios.  We are simply deducting the earnings quality score of our shorts from our longs.  The higher the line, the larger the quality spread.

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FAQ

As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for a simple, concentrated, low turnover, and hard-hitting GARP investing strategy, we would like to talk with you.  Similarly, if you are looking for a model portfolio of the most proven and durable dividend payers that is simple to implement, please let us know.  KCR also offers a wide range of easy-to-use but sophisticated tools like our Equity Duration product, which allows you to estimate a given portfolio’s interest rate and inflation risk. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.

Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.