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Take a walk down Quality Street in 2023

A front-view shot of a multi-ethnic family with two children walking down a city street on a cold December night.

For most investors, 2022 was a year to forget.

Sure, if you owned oil majors like BP and Shell – both up more than 35% – then you were happy.

The high proportion of commodity firms in the UK’s FTSE 100 index meant that for once our market trounced the world, too – albeit with barely-there growth for the year.

Flat is plenty good enough when everything else is going down.

But who – outside of Texas – really has all their money in oil stocks?

I’d hope you don’t have all your money in the FTSE 100, either, given the UK stock market represents less than 5% of the total global market capitalisation.

All are punished

No, most of us have more sensibly diversified portfolios. Which in 2022 only meant that we had the dubious pleasure of seeing all sorts of different things crash at once.

The rout of disruptive growth companies and technology stocks – the darlings of the pandemic – was surely the most spectacular. Many former favourites are down 90% or more.

But perhaps of greater interest to Fools – and much less widely reported – was the kicking given to the best-in-breed ‘quality’ companies of the sort we aspire to buy and hold forever.

Those same rising interest rates that called time on the speculative frenzy in profitless IPOs and cryptocurrencies also hit the valuations of quality shares.

Higher rates popped the stock bubble by putting a price on money again, after years when borrowing was virtually free.

But with quality companies, the impact was more subtle.

Quality companies invariably have strong balance sheets, little debt relative to earnings, and they throw off cash like they’re printing the stuff. Higher rates don’t see their leaders losing much sleep.

However, higher rates do prompt stock market analysts to furrow their foreheads and revisit their best estimates as to what investors should pay for any given stock – even the best of them.

Deep discounts

That’s because the most popular way to value shares is by doing what’s known as a discounted cash flow model. And when interest rates soar, you need to redo all your sums.

With a discounted cash flow analysis, you tot up all the cash you think (/guess!) a company will earn for the rest of its life.

However, you discount the value of future cashflows back to today, before doing the final tally.

Discounting reflects the fact that money in the future is worth less than money you have right now.

How much less? Well, that depends on what discount rate you choose.

Discount rates vary for many reasons. But they are nearly always strongly influenced – lifted or lowered – by prevailing interest rates.

When discount rates go up, the value of future cashflows fall. This means hiking the discount rate employed in your sums by just a few percent can seriously ding the valuation of a stock.

You could easily see your estimate of a growth company’s value cut in half compared to this time last year, before interest rate rises really got going. Worse still for very high growth companies. That explains a lot of the carnage in the markets this year.

Lightbulb moment

So much for the science bit. But there’s another, more intuitive reason why quality companies aren’t quite as highly prized these days.

You may have heard such companies described as ‘bond proxies’ in the past. The idea was their profits and dividends were so reliable – relative to other shares – that investors starved of income could own them in place of bonds.

The logic behind this trade was questionable in my view. Nevertheless, it was commonplace – and indeed one reason why central banks took rates so low. They actively wanted to encourage investors to take more risk, to grow the economy following the financial crisis.

But everything changed in 2022.

Having been wrong-footed by runaway inflation, central bankers set about hiking rates faster than you can say “how many economists does it take to change a lightbulb?” *.

That didn’t just smash the stock market. It also caused a rout in the bond market.

The result now the smoke has settled is that you can buy high-quality government bonds yielding 3-4%.

Which means nobody is talking much about bond proxies any more. There’s little appeal for safety-first investors when they can buy the real thing for income, without the messy uncertainties of even high-quality shares.

It’s thus been a double whammy. Rising rates have hit the valuations of quality companies, while at the same time many investors who had been reluctantly buying them in the past decade can retreat back to boring old bonds.

Hey ho. Nobody said you couldn’t lose money investing in quality companies.

(Actually, some people did say that. I hope you ignored them!)

A trio of quality companies

So much for the medicine – let’s end with some sugar to wash it down.

The de-rating of quality stocks has been painful for investors. But it’s in the past.

Share prices have come down hard, yet their business prospects to me seem relatively bright.

Which means you can now aim to buy better companies – and all their lovely future earnings – cheaper than before!

Here are three to get you started with your research:

Halma (LSE:HLMA). An engineering conglomerate comprised of more than 40 different subsidiaries doesn’t sound like a recipe for quality. But Halma has been consistently growing profits for decades. Halma produces mission-critical components, often for regulated industries, which gives it a strong market lock and pricing power. Return on equity invariably hovers around 20% – a sure sign of quality. And with Halma’s shares down 37% in 2022, it trades on a mid-20s P/E (price-to-earnings) ratio, versus 40 a couple of years ago.

Rightmove (LSE:RMV). Everybody knows Rightmove, the online property portal. But if you thought your property porn addiction was bad, spare a thought for estate agents who can’t stop spending money on this all-important platform. Revenues, profits, and dividends have steadily risen for a decade. Yes, the housing market is slowing – but Rightmove makes money from rental agents too. Rightmove’s P/E has fallen from 30 before the pandemic to around 20 today thanks to a 35% fall in its share price in 2022. Lower P/E ratings are only a shortcut when valuing a company but, given quality firms’ steadier earnings, lower P/Es do tend to indicate better value.

Unilever (LSE:ULVR). My final suggestion actually saw its share price rise in 2022, albeit by just 5%. But it was a welcome tonic for Unilever shareholders frustrated by the consumer giant’s share price spinning its wheels for half a decade. Indeed, Unilever’s shares only recently retook the level first hit when US rival Kraft Heinz bid for the company in 2017. Happily the business is doing rather better. The £105bn behemoth steams on, reaching deeper into emerging markets, raising prices to counter inflation, and growing a dividend that offers a better than 3.5% yield. With famed activist investor Nelson Peltz on the board and the current CEO set to retire, 2023 could be exciting. And a P/E below 20 might tempt bargain hunters, again given the stability of earnings here.

Feel the quality

Most of the world’s economies are forecast to slow over the next 6-12 months, as the delayed impact of those interest rate hikes hits home. Recession predictions are ubiquitous.

Yet quality companies are renowned for their more robust business models. They can soldier on through slowdowns compared to more economically sensitive or cyclical stocks. And their strong market positioning gives them the pricing power to keep ahead of high inflation.

As such, quality stocks are better placed than most to weather any storms ahead. Yet you can buy them cheaper today than this time last year, when everything still looked rosy in the global garden.

I told you there was a bright side to falling share prices!

*“None. If the lightbulb really needed changing, market forces would have already caused it to happen!”

The post Take a walk down Quality Street in 2023 appeared first on The Motley Fool UK.

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The Motley Fool UK has recommended Halma Plc, Rightmove Plc, and Unilever Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.