Quality Investing as a Hedge to High US Equity Valuations

Investors are starting the new year with one question in mind: can US equities continue their 2023-2024 rally, or will 2025 be the year when US equity valuations finally come back to earth?

Betting against the US equity market has been an expensive trade in recent years with the S&P 500 up 26% in 2023 and 23% in 2024, leading many to consider strategies which can mitigate draw-downs without sacrificing upside exposure. To this end, long-short equity quality (buying quality and selling junk stocks) is relevant as a defensive strategy.

While every bear market is different, they share similar characteristics, one such being a flight to quality stocks and away from junk stocks. This dynamic is particularly evident during longer, more drawn-out draw-downs, such as the dot-com bubble, which are characterized by reasonable levels of dispersion and implied volatility (situations which many traditional hedges such as protective put options struggle with).

As shown in the above chart, a flight to quality and away from junk was observable in every bear market since December 1999 and is in line with basic economic intuition: quality stocks, which we define as those with comparatively low leverage and high profitability, are better able to weather the storm than junk stocks, defined as those with comparatively high leverage and low profitability.

However, what’s really interesting about long-short equity quality is that quality also tends to keep pace with or even outperform junk during bull markets. In a rational market, quality stocks should trade at a premium to junk stocks as quality characteristics such as safety (low leverage) and robust profitability should correspond with lower discount rates, higher future cash flows and correspondingly higher valuations. But empirically this is not the case: between Dec-1999 and Nov-2024, the average P/E ratio of the long quality US index in figure 2 was 29, vs. 33 for the short US quality (junk) index. What explains this?

While the literature on this topic is not settled, the most commonly cited explanation is investor leverage constraints. Economic theory dictates that investors should hold a combination of the ‘tangency’ portfolio – a combination of risky assets optimized to deliver the highest possible risk-adjusted return - and the risk-free asset, leveraging their holding in the former to achieve their desired risk budget via a long or short position in the latter.

This theory fails in practice as most investors are constrained from taking leveraged positions in equities; as a sub-optimal alternative, many such investors seek to achieve their desired equity beta (volatility) by investing in higher beta junk stocks, essentially getting their leverage at the stock, rather than portfolio, level. These sub-optimal flows drive up the valuations of junk stocks, as is evident during strong bull markets (junk rallies), such as 2009-2010, 2013-2014 and more recently through the latter half of 2020 and first half of 2021 (see chart above).

Long-short quality can underperform during periods of widening junk-quality valuation spreads, though this is not always the case - quality stocks’ higher profitability is often a symptom of a defensive moat, allowing them to either productively reinvest their excess cash flows or return capital to shareholders, in both cases generating returns without valuation expansion.

By contrast, the valuation expansion of junk stocks is rarely justified and has historically reverted either during a market draw-down (e.g. dot-com bubble, GFC & COVID-19) or simply as a revaluation during more benign markets, with the second scenario being a key reason why long-short quality portfolios are able to generate positive performance in times of calm as well as times of crisis.

Furthermore, the strategy is sector neutral by design, meaning it isn’t at risk if, for example, tech stocks fall out of favour. Instead, the strategy seeks out high quality stocks within tech for the long basket while choosing junk tech stocks for the short basket, a process repeated across all sectors.

We cannot tell you what 2025 has in store, but we can tell you that we enter the year with a significant junk-quality valuation spread, a gulf which has grown persistently since the latter half of 2023: The US junk basket now trades at a P/E of 32, vs. 24 for the quality basket. As for whether this valuation spread reverts as part of a market crisis or simply through the course of things, time will bear witness.

To learn more about this topic, please contact Ross French.