Quant Strategy: Focus on Quality over Value
The author is an analyst of Shinhan Investment Corp. He can be reached at sangho.kim@shinhan.com. -- Ed.
On March 13, the KOSPI and KOSDAQ indexes plunged by more than 8%, triggering the first-ever double circuit breakers (temporary trading halt). The Korean government held an emergency policy meeting to discuss measures to address market turmoil, while the Financial Supervisory Service raised the capital market crisis level from “caution” to “alert.”
Growing uncertainty from the COVID-19 spread and sharp oil price falls has expanded volatility in the financial market and driven panic selling by foreign investors. The KOSPI saw daily fluctuation of 153.7pt on March 13, the third highest level following 185pt recorded in August 2011 (sparked by credit-rating downgrade to US sovereign debt) and 158pt in October 2008 (collapse of Lehman Brothers). The benchmark index’s volatility (60-day standard deviation of returns) soared to its highest level since 2011.
Foreign net selling started at the end of January and increased gradually to reach a new weekly high of KRW5tr last week (vs. previous high of KRW3.6tr in the second week of January 2008). Foreign investors have net sold KRW11.5tr worth of Korean stocks since January 21 when COVID-19 started to spread nationwide.
Such panic selling by foreign investors will highly likely ease gradually as the US Fed cut its benchmark rate to a target range of 0.00-0.25%, and launched a massive USD700bn quantitative easing (QE) program on March 15.
Historically, the Korean stock market saw an inflow of foreign funds after QE by the US Fed. Every QE program led to a short-term inflow of foreign capital, but different patterns were observed after one month. While foreign capital continued to flow in for three months during the QE2 run, it began to flow out after one month during Operation Twist due to the escalation of the European fiscal crisis.
Injection of liquidity is certainly positive for stock markets. However, a steady mid/long-term inflow of foreign funds will be possible only when credit risks (risks of sovereign default and corporate bankruptcy from the COVID-19 outbreak and steep oil price falls) have been addressed.
Focus on quality over value
Valuation is an important factor when investing as discounted valuation acts as downside protection in a crisis. PBR, the price/book value ratio, is mainly used to estimate the downside risk for the KOSPI and individual stocks based on past crisis data. The problem is that it is difficult to determine the discount rate in the current crisis, with uncertainty rising over corporate earnings and book value getting unreliable.
The YTD data on foreign net purchase value to market cap ratio shows that value stocks were most oversold by foreign investors. Most value sectors suffered an outflow of foreign funds, except for those with limited earnings uncertainty like telecom service.
In contrast, foreign investors net purchased growth stocks (software, consumer staples, IT hardware), excluding hotel/leisure and cosmetics stocks affected by uncertainties at home and abroad. They favored stocks with high growth potential over cheap stocks on a book value basis.
Such preference for growth stocks is a global trend as shown by the relative performance of the quality index (strong fundamentals) to the value index. The global value index includes stocks with low PER/PBR and high dividend yield, while the quality index consists of stocks with high profitability (in terms of ROE) and fiscal stability (debt-to-equity ratio).
The quality index outperformed the value index during the past financial crisis (2007-2008) and European fiscal crisis (2011-2012). More recently, quality has seen a sharp rise in its relative strength to value since November 2019.
The domestic quality index is also faring well this year. The MKF500 quality index has delivered a negative return of 14.9% YTD, outperforming the negative 24.8% of the value index by 10%p (vs. MKF500 -18.4%, KOSPI -19.4%). The quality index maintained relative strength for long in 2011-2015 when uncertainties continued at home and abroad. As such, quality should continue to outperform value amid the ongoing crisis sparked by COVID-19 and sharp oil price declines.
High quality vs. low quality
Stocks can be divided into high-quality and low-quality stocks based on profitability and fiscal stability. Profitability is measured by ROE and ROA, and fiscal stability by debt-to-equity ratio and current ratio. Here, we categorize domestic stocks in the top 30% in terms of profitability and fiscal stability as high-quality and those in the bottom 30% as low-quality. Amid current uncertainties, we recommend focusing on high-quality stocks.
