AA PM-rated stock wary of when quality stocks explode

Coca-Cola may be a household name, but the beverage giant’s steep decline in the 1970s should serve as a wake-up call to any investor seeking refuge in so-called “quality” names.

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

In a blog post titled ‘When quality fails’, the US-based manager said value and quality are often at odds and – his own biases aside – quality hasn’t come under scrutiny. the same scrutiny that value investing has faced in the past. decade.

“We raise this question because, in many ways, this is the real problem with equity investing in 2022 and the sore spot for the S&P 500 over the next decade. We’ve heard that price-earnings ratios (P/E) do not take the balance sheet into account.

“The balance sheet is a way to test the quality of a company in the analysis of security. P/E ratios are just one measure of the many metrics of value against the income statement. However, these factors can work against each other and even contradict each other.

Smead said quality became the dominant trait of stocks in the post-dotcom bubble era, as investors gravitated toward companies that could post tangible balance sheets and earnings. However, he said there are stark similarities to the ‘Nifty Fifty’ stocks which were the long-term winners, but the reality was quite different.

Focusing on Coca-Cola, Smead said the company’s net cash had fallen from $234 million in 1972 to $178 million in 1979, despite an increase in profits from $198 million to $420 million in during the same period. However, taking dividend payments into account, investors actually lost 49.44% over that seven-year period in cumulative terms.

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

“If all these quality elements were in their favour, what was killing investors? What made them fail was value. As Siegel points out, Coca-Cola was trading for 48 times its earnings by the end of 1972.

“At the end of 1979, they were trading at 10.15 times earnings while holding more cash than debt and producing over 20% return on equity. It’s a perfect picture of when quality fails.

What is the next step ?

Smead said the lesson for investors today is that there is a feeling that clinging to perceived quality will insulate investors from any downturn. He pointed this out against the backdrop of the US store avoiding big names such as Amazon, Costco and Microsoft, despite the clamor of other investors.

“These companies could be incredibly successful in their operations over the next 10 years, like Coca-Cola did in the 1970s. In the end, investors might hate them anyway. It shows you how bad the nightmare is when quality fails,” he said. ‘Fear the failure of the stock market.’

The latest fact sheet for the $238.3 million Smead US Value fund, which runs through the end of March 2022, shows that the top investment areas are consumer discretionary (24.6%) and consumer discretionary. energy (24.5%). It was then that the largest equity positions were energy giants Continental Resources (9.6%) and Occidental Petroleum (6.7%).

The Smead US Value fund returned 49.6% in US dollars over the three years to the end of April 2022. This is when the average fund in the Equity – US Value sector returned 31.7% over the same period.

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