It’s time to add some quality to your portfolio—quality stocks, that is.
What are quality stocks? They’re exactly what they sound like. They’re the shares of companies that have high, stable profit margins, insulating them from potential losses if sales take a hit. Some are in stable sectors where revenue holds up even when the economy suffers. Some have longstanding brands that they can leverage to find new ways of growing. Many have large balance sheets, which means they don’t need to raise money, an advantage when interest rates are high. Needless to say, the stocks of high quality companies are largely safer investments than lower quality ones, all else being equal.
The
iShares MSCI USA Quality Factor
exchange-traded fund, up 25% since the start of the year, has topped the
S&P 500’s
21% gain, driven by large gains in
Apple,
Microsoft,
and
Nvidia,
which make up about 13% of the ETF’s portfolio.
Meta Platforms
and
Alphabet
are high up the list as well. Since Nov. 15, however, the quality ETF has risen just 0.8%, while the S&P 500 has gained 1.5%. That’s because the market has bid up cheaper, more economically-sensitive stocks in the past few weeks.
That Big Tech makes up a big chunk of the Quality ETF makes sense. The companies have higher profit margins and bulletproof balance sheets. The group has been using artificial intelligence to enhance products and create additional revenue streams, and they are meeting analysts forecasts for double-digit profit growth. But they’re not the only ones in the ETF. The fund’s biggest position, for instance, is
Visa,
and it also has large stakes in
Nike,
UnitedHealth Group,
and
Eli Lilly.
With the fund taking a break, it’s a good time to take a look at high quality stocks. That’s why 22V Research screened for high quality stocks that have performed poorly recently but have been executing their strategies. Some stocks on the screen are
Adobe,
PriceSmart,
National Beverage,
and
ServiceNow.
“We expect the headwind from November’s extreme rotation [away from quality] should fade and the model performance should improve in December,” writes 22V Research’s Dennis DeBusschere.
Cigna
stock looks particularly interesting. Its stock is down 19% from its high for the year, and recently slipped amid reports that it might be in talks to merge with
Humana.
It’s also cheap, fetching just 9.3 times earnings per share estimates for the coming 12 months, roughly half the S&P 500’s multiple. The issue is that Cigna’s rumored interest in buying Humana would drastically increase the number of shares in the combined company, weighing on earnings per share. Cigna, with a market value of $76 billion, has about $8 billion in cash, so it would need to issue tens of billions worth of stock to buy the $60 billion Humana, in a deal that RBC analyst Ben Hendrix estimates would likely top $70 billion.
While 2024 EPS for the combined company would be about 8% lower than Cigna’s stand-alone earnings, Hendrix writes, growth should ultimately bring earnings per share higher. Billions of dollars of cost synergies, mostly relating to salary expense, plus ongoing sales growth, would ultimately increase earnings over the years. And that’s if a deal happens. Analysts remain skeptical that the Federal Trade Commission would allow the two companies to combine.
Either way, there’s growth to come for Cigna. Analysts expect revenue to grow at about 13% annually for the next four years to $315 billion by 2027. It’s ramping up its Evernorth health services business, which includes pharmacy benefits, home delivery of products, and health solutions. The goal is to better understand each member’s health needs, reducing costs for both members and Cigna, which is partly why analysts forecast mid-single-digit premium growth over the coming four years.
Now that’s something you don’t see too often—quality and cheap.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com
Read the full article here