Earnings Quality and Stock Returns with Value as a Tailwind

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:

Value spreads between our long and short portfolios are coming off the highest levels ever recorded
Earnings quality spreads are just shy of the record observed at the height of the dot.com bubble
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:

Some of the most profitable and well-run companies are also among the least expensive
Some of the most expensive stocks in the market are also unprofitable, poorly run, and sport lax accounting
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.

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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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SOURCES

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.

SERVICES

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 simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you. KCR also offers a wide range of easy-to-use but sophisticated tools. Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. 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.

Disclaimer

The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital. In preparing the information, data, analyses, and opinions presented herein, Kailash Capital has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital, however, does not perform an audit or seek independent verification of any of the data, statistics, and information it receives. Kailash Capital and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction.

Nothing herein shall limit or restrict the right of affiliates of Kailash Capital, LLC to perform investment management or advisory services for any other persons or entities. Furthermore, nothing herein shall limit or restrict affiliates of Kailash Capital, LLC from buying, selling, or trading securities or other investments for their own accounts or for the accounts of their clients. Affiliates of Kailash Capital, LLC may at any time have, acquire, increase, decrease or dispose of the securities or other investments referenced in this publication. Kailash Capital, LLC shall have no obligation to recommend securities or investments in this publication as a result of its affiliates’ investment activities for their own accounts or for the accounts of their clients.