”Glöm kvalitetsjakten – nu kan skräpaktier få revansch”

The dash for trash.

Finance is peppered with jargon that doesn’t make much sense: “investment-grade bonds” (unlike those other, uninvestible ones), “forward guidance” (as opposed to the backward kind), “convexity adjustments” (translation: your trader wants more money) and so on. Still, it can be exasperating to hear an investment adviser sagely recommend “quality” stocks, as if without their wisdom you would seek out dross.

In fact, now is the moment to do just that. An eccentric conclusion to draw, you might think, as the world’s rules-based order breaks down, its dominant superpower attacks enemies with impunity and vital shipping lanes are blocked by war. Surely such times call for the haven of high-quality stocks?

To see why not, start with that jargon. Unlike other, better-defined “factors”—size, value, momentum—quality has only a loose meaning. Investors and academics use it variously to refer to profitability growth, earnings stability, investment patterns, as well as wafflier concepts like corporate governance. This is unfortunate, for it obscures a useful idea.

In 2015 Eugene Fama, a Nobel-prizewinning economist at the University of Chicago, and Kenneth French of Dartmouth College published a paper outlining a narrowly defined “profitability factor”. Getting exposure to this entails buying shares of profitable firms and short-selling unprofitable ones. Perhaps because it seems glib to say that profits are good and losses bad, people started calling the factor “quality” instead.

Though today investors differ on exactly which parameters determine a stock’s quality, most agree that they include profits which are high, stable and, preferably, growing. Low debt (relative to profits) also helps. Such virtues seem especially valuable during periods of high uncertainty—and on March 9th Wall Street’s “fear gauge”, the VIX index, hit its highest level since the tariff-induced panic last April. The turmoil was down to the American-Israeli war against Iran, which began with air strikes on February 28th, and in particular the threat of it restricting the world’s oil supply. Yet since markets closed on February 27th, the subindex of quality stocks in the S&P 500 benchmark has fallen by more than the main index. The same is true of the broader MSCI World Quality index, a subset of the MSCI World.

One reason is that, as Adam Parker of Trivariate Research points out, the market value of high-growth firms has become significantly skewed towards high-quality ones over time. America’s tech giants epitomise this trend: excluding Tesla, all have increased their earnings both reliably and at a clip ranging from impressive to gob-smacking. They have also seen their market values balloon, both in dollar terms and as a share of the overall market.

The downside of the broader overlap between growth and quality stocks arises because much of a growth stock’s value comes from the far higher earnings investors expect of it in the distant future. These are inherently uncertain, however reliably the firm’s earnings have grown in the past. And so quality stocks now take a bigger hit when the world becomes more fractious and unpredictable, since this calls into question the future earnings that investors are disproportionately banking on. Quality does not, in this world, denote safety.

A corollary is that the junk stocks left behind by their fast-growing counterparts derive a greater proportion of their value from near-term profits. They might be ho-hum, but they are also almost within reach, so less vulnerable to disruption. A glance at the sectors represented in the S&P 500’s lowest quintile, quality-wise, shows the difference. Firms offering discretionary goods, financial services and health care all loom large. Energy firms make up 9% of the lowest quintile’s value, compared with less than 1% for the quality subindex (and have benefited from the jump in oil prices caused by war in Iran).

Should the oil shock persist despite President Donald Trump’s desire to end hostilities, it might well be time for the rubbish to shine. Mr Parker has analysed low-quality shares’ historical performance after oil spikes, which he defines as price rises of more than 35% within three months. (A barrel of Brent crude, the global benchmark, is now around that much more than three months ago.) He found that the trashiest stocks rose by 8% on average in the six months after the spike, compared with 4% for the highest-quality ones. “Buy quality” might appear to be eye-rollingly obvious advice. Just now, it might also be wrong.

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