Stock markets: Is there a bubble in the valuation of quality stocks?

Published: November 22, 2019 12:13:39 AM

The best way to compare the performance of quality stocks vis-à-vis others on return, risk and valuation parameters is to compare the performance of quality index vs broad-based benchmark index

Both NSE and BSE have launched quality factor indices.Both NSE and BSE have launched quality factor indices. (Illustration: Shyam Kumar Prasad)

By Mayank Joshipura

We have been hearing a lot about the bubble in quality stocks. The argument is that the quality stocks are pricey and they will deliver inferior returns going forward as the prudent investment thesis of “quality-at-a reasonable-price” is stretched too far to “quality-at-any-price” and hence valuation of quality stocks has touched stratospheric heights. We will try to test whether there is a bubble in quality stocks.

How do we define quality stocks?
The first question is how do we define quality stocks? And do they deserve premium valuation compared to other stocks? While quality businesses have several intangible dimensions such as superior management bandwidth, high corporate governance standards and strong economic moat surrounding their businesses, for the valuation of stocks four things matter: profitability, growth, risk and pay-out. The firms with higher profitability, higher top-line and bottom-line growth, stable earnings and low leverage and keen to share surplus cash with shareholders naturally enjoy premium valuations in the form of price-to-earnings or price-to-book multiples.

So, quality stocks trade at a higher valuation than others. There is no debate about it. The question is whether the quality premium has gone too far and economic moats and superior fundamentals cannot justify it. Let us try to test it without cherry-picking stocks to prove the argument one way or the other.

Is there a bubble in quality?
Both NSE and BSE have launched quality factor indices. I am using one of the NSE quality indices to test the long-term performance of quality factor and bubble in the valuation of quality stocks now. NSE quality indices select stocks with higher profitability, lower leverage, and more stable earnings from the universe of stocks. NSE200-Quality30 index selects 30 stocks based on the above criteria from a broader universe of Nifty200 index constituents. So, the best way to compare the performance of quality stocks vis-à-vis others on return, risk and valuation parameters is to compare the performance of quality index versus broad-based benchmark index.

The graphic shows that the Nifty200-Quality30 index has delivered superior returns compared to Nifty 200 index for one-year, five-year and a 15-year investment horizon. However, its one-year and five-year returns are not very different from Nifty 200 returns. If there is a bubble in quality stocks, one-year and five-year return of Quality index should have been much higher than Nifty 200 returns. The real quality premium is visible in long-term returns where the quality index has delivered 19.3% CAGR vs. 13.85% CAGR of the Nifty 200 index. Turning attention to risk, quality stocks are less risky and therefore both standard deviation and a beta of the quality index are lower than Nifty 200 index. So Quality index has delivered superior returns at a lower risk.

The writer is professor (Finance), School of Business Management, NMIMS Mumbai

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