Do Quality Shares Lead to Lower Returns for Your Portfolio?

Managing your own stock portfolio is not easy. One of the many important decisions is choosing between quality and returns. Is there a cost in investing in high-quality shares? Could buying them lead to lower returns?

There’s no simple answer. However, your rate of return on a stock depends largely on the valuation you paid and the growth rate of the company. Besides, there are other considerations outside of aiming for high returns.

Let’s explore the answers with examples, including Microsoft Corporation (NASDAQ:MSFT), The Coca-Cola Co (NYSE:KO).

Quality companies tend to trade at premiums

Some say you can get quality and returns too. The rationale being that when you buy quality companies, their steadily rising earnings will lead to steadily rising share prices. However, if you overpay for them, the expected returns will likely be unsatisfactory.

Here’s an extreme example. If an investor bought Microsoft at the peak of the Internet bubble in 1999, it would have taken about 17 years for his investment to break even.

The Coca-Cola stock tends to trade at a premium, and many view its dividend to be safe. In the last 12 years or so, its normal multiple was 19.5. At under $41 per share, the beverage company trades at a multiple of 21.3, higher than the multiple of 18.2 in 2011 even though the earnings per share for this year and in 2011 are expected to be roughly the same.

This combination of more expensive shares and stagnant earnings is alarming, especially since the company has continued to hike its dividend every year. Its payout ratio is expected to be much higher this year at 73% (versus 49% in 2011).

Some analysts believe that Coca-Cola’s earnings per share can grow at about 1.8 – 5% per year in the next 3-5 years. If the lower end comes true and Coca-Cola contracts to the lower multiple of 19.5, it’d mean a 4% annualized return. This is too low of a return for my taste.

More discussions on quality and returns

This article originated from my Seeking Alpha article. You can read the full article here: Do You Want Quality or Returns?

In the article, you’ll see more examples with Starbucks Corporation (NASDAQ:SBUX), CVS Health Corp (NYSE:CVS), W W Grainger Inc (NYSE:GWW), 3M Co (NYSE:MMM), Exxon Mobil Corporation (NYSE:XOM) and Seadrill Ltd (NYSE:SDRL). And it’ll explore the answers to these questions:

  • Do quality companies deliver more stable returns?
  • Do lower-quality companies deliver higher returns?

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Disclosure: At the time of writing, the author owns shares in Starbucks and CVS.

Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.

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