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Quality shares and the valuation re-set

Interest rate hikes are priced into valuations, is quality fairly priced?
April 4, 2022
  • Valuations adjusting to hawkish central banks
  • Large number of cyclicals in quality screens suggests a stock-picker's market

Top of our UK large-cap screen is software and cybersecurity company Avast (AVST), which saw its shares fall sharply in March on news the Competition and Markets Authority (CMA) wanted to refer the agreed merger with NortonLifeLock to a Phase 2 investigation.  The parties involved in the merger expect it to complete in the second half of 2022, noting that other regulators in the USA, Germany and Spain have reviewed and cleared the merger. 

Other high ranking UK large-cap shares include miner BHP Group (BHP) and, representing another controversial sector, British American Tobacco (BATS). In the case of BHP, the concern would be the cyclical nature of the industry and it fails our next year earnings per share growth test. Really, mining stocks wouldn’t fit a textbook definition of ‘quality’ thanks to these cyclical risks. However, given the potential for stagflation (recession accompanied by inflation), miners that are exposed to rising commodity prices and have a track record of returning cash to shareholders via dividends and buybacks are a useful holding. In rare times of stagflation, tobacco stocks like BATS are also good for investors who don’t have a moral issue with them.  Low growth in much of the economy means dividends are a really important part of total returns, so the inelastic demand for tobacco products and the subsequent pay-outs from the manufacturers to shareholders are tempting. 

One company that made it into the list but must be disregarded for obvious reasons is Russian-linked steel manufacturer Evraz (EVR). Although it passes seven out of nine tests, the reality of the international situation isn’t shown by the numbers. 

Many very profitable quality companies are still expensive, both those listed on the UK and the US  stock markets.  Still, it is notable that the negative three-month share price momentum for names like Diageo (DGE) in the UK and Apple (US:AAPL) and Microsoft (US:MSFT) from our S&P 500 screen is in the single digits, despite the hawkish signals from central banks (higher interest rates make profits made by these big earners not worth paying so much for).  As aggressive rate hikes are better priced in, it will be worth looking to identify where the support level prices are for these businesses that have enduring quality characteristics. 

Looking at our small cap screen, which covers smaller Aim and main market UK shares, the outputs are better interpreted with a cyclical mindset rather than looking at stocks that can be bought and forgotten about. Mining companies are prominent, which underlines this point.  It’s also interesting to see companies that have experienced relatively heavy sell-offs in their shares scoring highly on quality metrics. The many small-cap screen results here definitely fall into the “investigate further” bucket, rather than being screaming “buys”.

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