Quality shares: balance valuation and cyclical risk

Investing in the shares of quality companies with strong balance sheets and robust profitability is a well attested-to method of building returns. Yet there are pitfalls, notably that these companies become so popular that the shares get very expensive, and this valuation risk means they are vulnerable to price falls on macro economic news or even the slightest disappointment in performance.  So, along with quality, there needs to be some focus on value - even if some of the best companies remain worth paying up for. 

Diversifying portfolio strategy so that not all shares held are priced expensively relative to expectations of future profits is sensible. However, it is also worth keeping in mind that companies in different sectors of the economy should not be valued the same way. 

IT company Kainos (KNOS) is valued on 53 times earnings estimates for the next twelve months according to our FactSet data, so the fact that it fails our price-to-earnings growth test should be a flag to pause and consider if it is now too expensive. Data business Experian (EXPN) has a NTM PE of 36, but it doesn’t fail a single test.  The other FTSE All Share companies scoring 9/9 are Hikma Pharmaceuticals (HIK) and mobile and IT network specialist Spirent Communications (SPT). These perfect score companies shouldn’t be avoided if they have long forward PE multiples, rather the quality signs are reassuring so long as the growth prospects are good.

Balancing valuation risk with some cyclical risk, investors might look to other sectors.  For example, several mining companies do well on our quality screen but have potential to be volatile on external shocks that affect commodity prices. It’s also worth noting that although they look cheaper than other flagged quality companies on Fwd PE, measures like share price to free cash flow or share price to net asset value are better metrics for the sector.