Quality theme: A house of cards?

Ask any seasoned investor what the most critical aspect of a sound stock investment would be and he’s most likely to say: price. But a look at the rally in the handful of bluechips in recent months suggests that the logic behind this theory has been thrown to the wind. The run-up in these 15-20 stocks — termed as ‘quality’ by market participants because of better earnings prospects even in challenging times — to giddy levels has some wondering whether the build-up is like the proverbial house of cards.

At the outset, it needs to be clear that there are no indications of stress in these companies. In fact, their prospects appear to be strong at a time when the downturn has made the earnings outlook hazier. These companies also have captured the imagination of those obsessed with moats. In investing parlance, a moat refers to a company’s ability to have a competitive advantage over its competitors that will help it maintain its market share.

Investors have been stacking up on these stocks hoping that they would help them tide over these tough times. But, the price-conscious on Dalal Street are increasingly getting uncomfortable with the value being assigned to them. Some of these companies are trading at price to earnings ratio of as much as 70 to 100 times. The Sensex and Nifty are trading at roughly 20 times estimated earnings.

Sceptics are questioning the riskreward in such investments. Backers of the ‘quality’ theme in the market contend it’s difficult to assign an appropriate valuation to companies with high predictability of earnings, especially in times like this. But, historically, rallies that have resulted in record high PE ratios have not sustained. An example of this is the end of the midand small-cap rally in January 2018 when their valuations — measured by PE — touched all-time highs.

The biggest challenge here, however, is that it’s not possible to predict a top for the market or stock based on valuations. High valuation per se is not a prime condition for a sharp sell-off. For instance, some of these ‘quality’ stocks have been trading at an elevated PE ratio of 50-70 times PE for almost three years. But, they continue to deliver steady returns.

So, what is making a section of the market cautious on ‘quality’? It’s not just valuations. The bigger concern is that the ‘quality’ trade, which has played out in 2019, has become a crowded one with investors and traders getting on the gravy train. The popular narrative around this theme is that price corrections in such stocks will not be sharp because of the earnings certainty.

But, stock market themes in vogue are always vulnerable to sharp declines because they are part of leveraged short-term trading strategies, which are unwound at the slightest hint of despair. Such market participants do not have the resilience to withstand a sharp correction. There have been adverse news flows related to these companies in the past but the stock declines have been modest because of the absence of punters. This time, the market will be less forgiving, and reaction could be much sharper.

Experienced investors are mindful of this. Many of them have been booking profits, forgoing the possible gains from such investments. The wait is frustrating. Investors, who exited from mid- and small-cap stocks after mid-2016 before their peaks on worries about their valuations, will vouch for it.

Some fund managers, who have significantly reduced their exposure to ‘quality’, have moved to shares of companies that have become cheaper after the recent sell-off and where earnings growth continues to tick though not at the same pace as seen a year ago. The logic here is that when the tide turns, a lot of the money will move to cheaply valued stocks. They face the risk of underperformance in their schemes till the time ‘quality’ works. But, as a money manager put it, “I prefer to be in a house of cards that’s work-in-progress than one that’s fully made.”