Quality Costs 25% Extra in Asia

The extra valuation enjoyed by the bluest of blue chips shot past 25 percent this earnings season.

Quality is trumping kitsch in Asia.

Shares of large non-bank companies with strong profitability and low leverage are starting to get a lot pricier versus similar firms with not-so-robust fundamentals. By one measure, the premium valuation enjoyed by the bluest of blue chips over their riskier counterparts shot past 25 percent this earnings season. The surge suggests the divergence may be heading toward the 40-percent levels last seen during the taper scare of 2013 or the height of the European sovereign debt crisis in the summer of 2012.

A rising quality premium is usually indicative of investors turning cautious and hiding in the relative safety of fatter operating margins, higher returns on equity and assets, and lower debt-to-equity ratios. The top 100 stocks, picked on those parameters from the 500 largest companies in the Asia-Pacific region, include companies such as Tencent, Taiwan Semiconductor Manufacturing, Japan Tobacco and KDDI. At the opposite end of the spectrum are 100 other large caps, including PetroChina, Sinopec, China Life Insurance and BHP Billiton, selected by reversing the quality criteria.

The former unsurprisingly enjoy higher price-to-earnings multiples, and the gap tends to narrow or widen in tandem with risk appetite. Right now, investors are defensive, and quality premiums are starting to soar. The most secure of Asian stocks currently have an average PE multiple of 19, compared with less than 15 for their flashier rivals. (Interestingly, there's no corresponding spike in the extra price shareholders are willing to pay for quality U.S. stocks, 1  which would appear to indicate that local worries, possibly related to the buildup of debt in China, are causing the nervousness.)

Paying for Excellence

Quality large-cap stocks in Asia have a 25 percent premium valuation over riskier bets *

Source: Bloomberg

* Selected from the top 500 shares by market value, based on leverage, operating margin, return on equity and return on assets; valuation refers to price-to-earnings ratio.

The median top-notch stock in Asia has an assets-to-equity, or leverage, ratio of about 1.5, compared with 3.3 for the median riskier security. Typically belonging to consumer, technology, telecom or health-care industries, these conservative firms also have superior profitability. Their 21 percent median operating profit margin and 13 percent return on assets are six and 10 times as high respectively as the median cyclical heavyweight, quite likely to be in energy or materials.

But do these differences pay? In turbulent times, yes.

Strong Companies, Superior Returns

Asian stocks with low leverage and high profitability outperform

Source: Bloomberg

* Market-cap weighted indexes of stocks selected by financial leverage, operating margins, returns on assets and returns on equity from among Asia's biggest companies; all indexes set at 100 on March 31, 2011.

Over the past five years, a market capitalization-weighted index of high-quality Asian stocks has returned 24 percent in dollar terms, versus 13 percent for lower-quality peers. While that premium might appear rich to some -- especially those who take the view the commodity downturn is over -- safety-first investors may push the valuations of a more defensive portfolio higher.

If the next 12 months are anything like the spring of 2012 or summer of 2013, and if China-related concerns intensify, that cautious camp could win the bet.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
  1. The U.S. quality premium is stable at about 15 percent.

To contact the author of this story:
Andy Mukherjee in Singapore at amukherjee@bloomberg.net

To contact the editor responsible for this story:
Katrina Nicholas at knicholas2@bloomberg.net

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