AA-rated value PM wary of when quality stocks go pop

Coca-Cola may be a household brand name but the beverage giant’s pronounced decline in the 1970s should serve as a warning for any investor seeking shelter in so-called ‘quality’ names.

That’s the view of Citywire AA-rated Cole Smead, who co-runs the Smead US Value fund with fellow Citywire AA-rated manager Bill Smead.

In a blog post, entitled ‘When quality fails’, the US-based manager said value and quality are often played off against each other and – his own biases aside – quality has not had the same scrutiny that value investing has faced over the past decade.

‘We bring this question up because in so many ways this is the real problem of stock investing in 2022 and the S&P 500’s pain point over the next decade. We have heard things like price-to-earnings (P/E) ratios don’t account for the balance sheet.

‘The balance sheet is a way to test the quality of a company in security analysis. P/E ratios are just one measure of the many yardsticks of value relative to the income statement. However, these factors can run contrary to each other and even be at odds with each other.’

Smead said quality has emerged as the dominant stock trait in the post-dotcom bubble era, as investors were drawn to companies which could post tangibly strong balance sheets and earnings. However, he said there are glaring similarities with the ‘Nifty Fifty’ stocks that were the deemed long-term winners but the reality was quite different.

Zeroing in on Coca-Cola, Smead said the company’s net cash dropped from $234m in 1972 to $178m in 1979, despite earnings rising from $198m to $420m over the same period. However, with dividend payments factored in, investors actually lost 49.44% over this seven-year period in cumulative terms.

‘Did Coca-Cola have a good capital structure? Yes. Did Coca-Cola have a sticky product? Yes. Did it have a bright future? Yes. Is this an easy business compared to other companies? Yes.

‘If all of these elements of quality were going for them, what was killing the investors? What caused them to fail was value. As Siegel points out, Coca-Cola was trading for 48x earnings at the end of 1972.

‘By the end of 1979, they were trading at 10.15x earnings while holding more cash than debt and producing over 20% return-on-equity. This is a perfect picture of when quality fails.’

Where next?

Smead said the lesson for investors today is that there is a sense that clinging to perceived quality will insulate investors from any and all downturns. He highlighted this in the context of the US boutique shunning big names such as Amazon, Costco and Microsoft, despite the clamour among other investors.

‘These businesses may succeed in their operations incredibly over the next 10 years as Coca-Cola did in the 1970s. In the end, the investors might hate them anyway. It just shows you how bad the nightmare is when quality fails,’ he said. ‘Fear stock market failure.’

The latest factsheet for the $238.3m Smead US Value fund, which runs to the end of March 2022, shows the largest areas of investment are consumer discretionary (24.6%) and energy (24.5%). This is while the single biggest stock positions were energy giants Continental Resources (9.6%) and Occidental Petroleum (6.7%).

The Smead US Value fund returned 49.6% in US dollar terms over the three years to the end of April 2022. This is while the average fund in the Equity – US Value sector returned 31.7% over the same timeframe. 

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