Is now the time for ‘quality’ stocks?

There is no better advert for good old-fashioned stock picking than a headline I saw earlier this week suggesting that UK pension funds are dumping US shares for fear of an AI bubble.

With the Magnificent Seven accounting for a quarter of the value of the US stock market, investors are clearly exposed to a correction in the prices of tech stocks. The Nasdaq index has risen by more than a fifth again this year and doubled since 2023.

Self-evidently, some parts of the market are frothy, and there are echoes of the dot.com bubble of 25 years ago.

But another headline jumped out at me this week. It said that so-called ‘quality stocks’ - those with high returns on capital employed, generous dividends, and persistent earnings growth - are trading at their lowest price relative to the broader market in a generation.

• Get updates on markets, ISA funds, pension saving and much more

There is a seeming contradiction in these two narratives. It feels like both can’t be true at the same time. But in a market of stocks, where one size does not fit all, it can.

To get a better handle on whether investors are right to worry about exuberant market sentiment or are being misled by a handful of important but unrepresentative shares, I turned to Factset, a market information database.

I looked at both the UK and US markets, as measured by their benchmark indices, the FTSE 100 and S&P 500. In both cases, I ranked all their constituent companies on five metrics: valuation, as reflected in a share’s price as a multiple of its earnings; a more sophisticated measure that compares this price/earnings ratio to a company’s earnings growth rate (the PEG); their dividend yield; how volatile their shares have been; and how much profit they generate as a percentage of the total capital they put to work.

These are standard yardsticks for fund managers, and any that pick stocks on their fundamental attractions, rather than simply trying to match the performance of an index, will be looking at these numbers every day.

I was struck by how much value there seems to be in the stock market today. I was also reminded of similar screens I conducted 25 years ago when, even as the dot.com bubble inflated in 1999 and 2000, there was no shortage of solid, but out of favour, investment opportunities.

I demonstrated a couple of weeks ago here that rotating from the popular tech stocks into out of favour defensive shares was a sensible strategy in 2000. And I suspect it will be so again today.

Looking at valuation, I was surprised by how many cheap shares are lurking in a US stock market that is widely viewed as the most expensive in the world. 73 of the top 500 companies can be bought for less than 12 times their expected earnings and about 125 for less than 15 times profit, a quarter of the total. Here in the UK, the situation is even better. Roughly half of the top 100 shares are priced at less than 15 times earnings.

Comparing that basic measure of value to the expected growth rate in earnings is an investment shortcut popularised as the PEG ratio by my old friend Jim Slater. It is shorthand for price-earnings-growth. He looked for shares trading with a PEG of less than one - in other words with a growth rate that exceeds the PE ratio. Again, there is plenty to choose from on both sides of the Atlantic. About one in ten US stocks have a PEG of one or less. They include well-known names like Citigroup and Hewlett-Packard. Over here, about one in six FTSE 100 companies qualify. Vodafone and Barclays have growth rates of twice their PE ratio, or a PEG of just 0.5.

When it comes to the dividend yield, the US is thought to provide thinner pickings than most other markets around the world. Investors there are more interested in growth than income. But a quarter of S&P 500 shares sport a yield of more than 3% and 25 of them have a yield above 5%. As you might expect, the UK offers even more to income investors. Half the FTSE 100 yields more than 3% and one in five companies pay over 5%. There are plenty of companies providing an income of more than 6%, including BP, Rio Tinto, Land Securities and British American Tobacco.

These are all measures of value, but turning to quality, there’s plenty to go for too. Perhaps the most important measure of a company’s strength is the return it can generate from the capital employed in the business. In the UK, the companies in the middle of the pack - the likes of Pearson, Reckitt Benckiser and easyJet - have annual profits worth about 9% of the capital they deploy. But there are plenty of stocks earning more than twice as much as that - RELX, Next, Admiral and Centrica all stand out. In America, I found more than 90 of the 500 leading companies delivering a return on capital employed of more than 20%. These include household names like Colgate-Palmolive and Visa, as well as newer entrants like sportswear retailer lululemon.

For investors looking to shelter from the choppiness that often comes at the end of a long bull market, low price volatility is attractive. Here, too, you do not need to stray far from the familiar names. PepsiCo, McDonald’s, Coca-Cola and Procter & Gamble bounce around less than a quarter as much as shares like Tesla, Palantir and Coinbase. Here, the low volatility shares include the likes of Unilever, National Grid and Imperial Brands.

To get an exposure to this type of high quality and attractively priced share you will need to look beyond the passive index-tracking funds that are increasingly the norm. But if you are prepared to dig around yourself or invest with a fund manager who has the skill to do it for you, there are plenty of opportunities.

This article was originally published in The Telegraph

Got a burning question you want to ask? Why not drop us a line. Click here to ask your question.

• Read: 5 stocks to watch in December
• Read: ‘ETF’ no longer means ‘passive’: the rise of active ETFs
• Read: Where to find the best dividends

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.