Via SeekingAlpha.com

Quality is a relative term, the same way that beauty is in the eye of the beholder. In my All-Equities SRG portfolio, I usually look at the resilience of the business model to make a quality assessment. Recurring or predictable revenue streams, cycle-agnostic demand and industry dominance are the three key factors that I pay most attention to.

Direxion defines quality from the perspective of ROE, net operating assets and financial leverage. At least this is the key criteria that the ETF manager uses to select stocks for the Direxion S&P 500 High minus Low Quality ETF (QMJ).

This fund starts from the assumption that “higher quality companies outperform lower quality ones over the long term”. To get the desired exposure, QMJ goes long high-quality and short low-quality stocks at a ratio of +150% and -50%, respectively. Below were the ETF’s top positions in May.

Long holdings:

  • Apple (AAPL): +8.4% allocation
  • Johnson & Johnson (JNJ): +8.3% allocation
  • Visa (V): +7.9% allocation

Short holdings:

  • Home Depot (HD): -2.8% allocation
  • McDonald’s (MCD): -2.3% allocation
  • JPMorgan (JPM): -2.2% allocation

The quick rise (and fall) of quality

QMJ is a new fund launched in early February 2020. Right out of the gate, the ETF experienced the most vicious bear market and one of the fastest recoveries in recorded history. The good news is that it has come out of the storm looking good.

Below is the performance of QMJ (blue line) against the S&P 500 (orange line) since February 19, the peak of the stock market. First, notice that the ETF has outperformed the equities benchmark by quite a bit – the dotted gray line helps to visualize the difference. The more nuanced observation is that the outperformance of quality happened mostly in the first three weeks of March, when panicked investors headed for the exits.

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But as of late, QMJ has started to lose its edge.

Source: DM Martins Research, using data from Yahoo Finance

The fund peaked against the S&P 500 on March 19, immediately prior to the bottom of the COVID-19 bear market. Since then, quality has fallen out of favor. The trend has been accelerating in the past few days. This is probably because the US has started to reopen its economy, boosting consumer confidence and investor morale.

Take a look at the graph below. It compares the performance of the S&P 500 (darker blue line) in the past two weeks against riskier and highly pro-cyclical sectors that I would be very cautious buying into at this moment: airlines (JETS), leisure and entertainment (PEJ), US regional banks (IAT), energy (XLE), REIT (VNQ) and small cap stocks in general (VB). These stocks are generally more sensitive to economic activity. They also boast weaker balance sheets in many cases and produce more erratic financial results.

Source: Yahoo Finance

Notice that “low quality” has been on the rise in the past few days. This is happening alongside optimism over a coronavirus vaccine and the reopening of businesses, but also at the same time that the economy continues to show signs of weakness.

Weekly unemployment claims continue to hit the seven digits. GDP contraction in the first quarter has been revised down to -5%. New home prices have been falling sharply (although demand for cheaper real estate has surpassed expectations). Now, add to the list of concerns the trade war with China, which has been picking up steam.

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Down, but not out

The revival of low quality during a market rally can be luring. But I bet that the trend will reverse again in favor of high-quality stocks, once the equities market is finally viewed as fully valued by investors.

When the COVID-19 dust settles, what will be left is a more fragile economy, including lower growth and much higher unemployment. For times like these, I would much rather hold a portfolio of high-quality stocks than one of more speculative names.

For this reason, and over a longer-term horizon, I expect to see QMJ shine once again. In my view, this is a matter of time and patience.

I use an approach that favors predictability of financial results and broad diversification when choosing stocks for my All-Equities Storm-Resistant Growth portfolio. So far, the small $229/year investment to become a member of the SRG community has lavishly paid off, as the chart below suggests. I invite you to click here and take advantage of the 14-day free trial today.

Disclosure: I am/we are long AAPL, V. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.