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.