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During the past few weeks, emerging market stocks and bonds and low-quality US stocks have been hammered. The amount of premium investors willing to pay to hedge their portfolios, as measured by the S&P 500 volatility index (VIX), has nearly doubled. Investors fear the global wave of cheap money and easy credit is about to end as central banks worldwide tighten purse strings.

In such an environment, risky assets invariably sell off most violently. This reversion to the mean has only begun.

There are a few things an investor can do:

  • Double down on risky bets, hoping for a relatively quick rebound
  • Trade risky stocks for high-quality large-cap stocks such as Medtronic, Berkshire Hathaway and Wrigley
  • Raise cash and stay out of the stock market altogether

If you are a fund manager, the first option can put you out of business. In spite of their recent pullback, risky assets such as small-caps and emerging market stocks are still up over the past few years, and could fall a lot further before hitting bottom. Buying them now may mean fast, easy gains if markets rebound, but if things get worse, there will be big losses and investor redemptions.

The third option is the safest, though it means locking in recent losses. But it is probably the best option for conservative investors.

My firm is following the second option because many quality large-cap US companies are compelling bargains at current prices, especially on a risk-adjusted basis. These are companies that Warren Buffett would label as having “wide economic moats” (think of a moat around a castle; the wider it is, the more protected the castle). They generate high returns on invested capital; have relatively low debt levels; can buy back their own stock; have predictable earnings and cash flows; and can increase earnings even in a recession as they have pricing power and scant competition.

Many of these high-quality companies are bargains today according to the following evidence.

Exhibit One: Standard & Poor’s classifies stocks into groups based on quality, with the A+ category including the highest quality companies (think ADP or Berkshire Hathaway); the B category holding slightly lower-quality companies; C being even lower quality, etc. Through April 30 of this year, there has been a high inverse relationship between the quality of a company and its stock market performance.

The A+ companies covered by S&P were up only about 1.5 per cent, B companies up more than this, and C companies up more than 15 per cent. Stodgy, “safe” stocks have been shunned in favor of risky stocks with higher earnings growth rates but much less certain prospects.

Exhibit Two: Morningstar rates the more than 1,500 stocks it covers in terms of the size of their economic moats; either “no moat,” “narrow moat,” or “wide moat”. About 10 per cent are rated wide moat. These wide-moat companies include Home Depot, Amgen, General Electric, American Express, and Ebay. I worked at Morningstar and am familiar with the history and methodology of these ratings.

After some quick research, I discovered there is a higher percentage of wide-moat stocks rated as “5 stars” (Morningstar’s “buy” rating) than at any time since October 2002.

Exhibit Three: The financial newspaper Barron’s publishes weekly a list of stocks that have hit their 52-week low price the previous week. There have recently been more Morningstar wide-moat stocks hitting 52-week lows than at any time since I started tracking this metric. Several of these blue-chip stocks have declined as investors reallocated money into small caps, commodity companies, and emerging market issues. This performance chasing nearly always ends badly.

Exhibit Four: My firm closely tracks a list of 15 mega-cap, high-quality companies. They include Berkshire Hathaway, Amgen, Coca-Cola, Anheuser-Busch, GE, Microsoft and others. Since 1999 when they were at their peak valuations, these stocks have produced an average annual return of less than 1 per cent, including dividends. In the same time period, their operating cash flows have grown by more than 80 per cent, on average.

Though there is no doubt many of these “nifty-15” stocks were overvalued during the 1990s stock market bubble, the pendulum seems to have swung back too far. Their cash flows and earnings have grown consistently every year since the bubble, yet their stock prices have gone nowhere.

The best way to play an environment of rising risk premiums, without giving up any upside in a rally, is to hold a portfolio of very high-quality US large-cap stocks. My favorites include Medtronic, Ebay, Wrigley, Microsoft and Dell. All are down this year but have done well in the past two weeks as riskier assets have plummeted.

Mark Sellers is a hedge fund manager with Sellers Capital in Chicago

msellers@sellerscapital.com

Copyright The Financial Times Limited 2017. All rights reserved.
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