B (13:59)

So you're about to make a trade based on a friend's text, but which u do you listen to? Is it we could buy a house.

C (14:06)

In Tulum.

B (14:10)

Get optioning those options. We could lose everything. Or let's do a little research, get your head in the trade and make the investment decision that's right for you. Learn more@finra.org TradeSmart.

D (14:30)

Welcome back. Let's talk about quality stocks. I do not recall any of the big investment banks a year ago putting out a note saying we are incautiously optimistic it's time to buy hot garbage. But that apparently would have been a pretty good call in 2025. The stock market in general did quite well. And UBS put out a Note late in 2025 saying that low quality stocks had outperformed high quality stocks by 50 percentage points since March. And it wrote that it's now time to bet on high quality. Quote the sharp rally in low quality appears unsustainable amid elevated uncertainty and extreme crowding. And I think there's something comforting and intuitive about the idea of buying quality almost no matter what you're shopping for. You could be kicking tires on a car lot, could be sniffing melons in the produce aisle. Look for quality seems to make sense. And especially now in the stock market, if you're worried about, let's say, runaway artificial intelligence spending or the rash of companies that we've seen with flaky business models, all those crypto treasury companies where the whole business model is basically buy and hoard crypto and hope it goes higher. If you're worried about that buy quality, there are only two problems with that approach. The first is there is not widespread agreement on Wall street on how to define quality stocks. So there are a lot of different funds with quality in the name that take quite different approaches. And the second problem is that many of these funds hold pricey stocks. The iShares, MSCI, USA Quality Factor, ETF, the ticker. There is Qual q U A L that traded recently at 26 times estimated 2025 earnings. That is a touch more expensive than the S&P 500 and the S&P 500 at the moment is pretty darn expensive relative to earnings. So is quality still a good deal if the stocks look expensive? I would say that overwhelmingly the most common measure that I see used to screen for quality stocks in these ETFs is something called return on equity. Basically, picture a fraction where the company's profits on the top and the net value of the stuff it owns on the bottom. How much profit are you generating using your stuff? That's return on equity. The problem is it doesn't really say anything about how expensive a stock is. Now, return on equity is a little more sophisticated than I'm making it seem here. There's something called DuPont analysis that can tell you why a company's return on equity might be too low and what you can do about it. It was developed more than 100 years ago by an explosive salesman for the Dupont company, back when it was largely in the gunpowder business. I'm not going to go into detail about that here. I covered it recently in a cover story for Barron's. Believe it or not, I ramble as much when I write as when I talk. Some would say more. One more thing I'll say about that qual ETF qu that's one of the big ones in the industry. It's expensive. It has underperformed the S&P 500 since its launch in 2013. But also when you look at the top holdings in the etf, you see Apple, Microsoft, Nvidia, Meta platforms, some of the same giants that dominate the S&P 500. So if you're buying a quality ETF because you own an S&P 500 fund and you're looking to diversify against that, you're worried The S&P 500 might not do that well going forward, and you want something on the side that could do better. That particular quality ETF might not look double different enough. And with that, I want to get to my conversation with Jared Woodard at B of A securities. He has a different way to look for quality stocks. At the end of this conversation, I'll be back with an ETF that Jared recommends. And also I ran my own screen recently for Barron's to try to find some quality stocks. I'll give you some of those names. Let's get to my conversation with Jared.

E (18:32)

The irony of looking for quality as an investor is it seems like you can't really be qualitative about it. You have to be quantitative. You have to measure something because you're going to want to run some kind of screen, probably to reduce the investment universe. Down to the stocks that you want to focus on and learn more about. So the question comes up, what are the measures that we should be screening for? And it seems like your research has pointed you toward free cash flow as an important one. Tell me about that.

C (19:03)

Well, there's a few different publicly available indexes and benchmarks that different folks are publishing that have done this work. Historically. If you look at free cash flow is it's operating cash flow minus capital expenditures. In plain language, it's the profits in a business subtracting the kinds of big investments that a company has to run over time to keep that business going. But with no other accounting components, that can sometimes be a catalyst for debate. So non cash charges, amortization, depreciation, what's happening with working capital? Is there stock based compensation? The goal with a free cash flow measure is to take away all of those, perhaps more debatable in some cases, perhaps even manipulable metrics, and focus on what cash is coming to the business. Cold hard cash.

E (19:50)

I've heard it described as cigar box accounting, where if you have a mom and pop store and they're putting the money in the cigar box and they're taking the money out of the cigar box, whatever money is left at the end of the day, that's what they've made. There's no what ifs, there's no yeah, buts. It's just the cash coming in and cash going out.

C (20:06)

That's exactly right. And here's why this has been so attractive to so many investors in recent years. Historically investing in a basket of stocks that score well on this measure. This free cash flow relative to enterprise value has performed about 15, 16% total returns per year since the early 90s. That's about 5 percentage points a year better than the S&P 500, which has already by itself been a pretty good place to invest.

E (20:32)

That's a pretty shocking margin.

C (20:34)

It's massive. It's massive. And it's the kind of margin that as an investor you get a little skeptical over time and you say to yourself that might have been true historically. Not sure how true that's going to be in the future. Let's see. And as I mentioned before, in some cases the returns in real time have been in line with history, which is a really fascinating result. If you look at other popular factors in the market that everyone knows about, momentum and growth and value and lots of other measures, some of those have had periods of outperformance, but nothing like this magnitude. And so I think it's a really ripe area for research. My colleagues at the bank have done a survey of investment professionals and I was stunned to see this. They asked all these professionals, like, what do you use when you're analyzing stocks? About 80%, I think said that they use a price to earnings multiple to gauge the value of a company more than half. Look at return on equity and you go down the list. Near the bottom of the list was this free cash flow to enterprise value metric that we like to use and so many others are looking at as a measure of quality. Only 25% of the folks surveyed said that this was a metric that was really on their radar.

E (21:38)

Okay, so tell me more about this moment in time for an investor who holds, let's say, an S&P 500 fund. I was reading in some of your research you were talking about valuations look a little high and what that meant for potential returns going forward. And you can talk to me about that. And you were saying that you can look at a number of different satellite strategies if you're looking to offset this. I forget the term you used an.

D (22:07)

Iffy core or I remember it made.

E (22:09)

Me think something someone might say about me in the gym, something about a core that was, you know, Your S&P 500, your core was uncertain. So you might need these other positions to augment it a little bit. Tell me about how the broad market looks and how quality can, can help with that.

C (22:26)

If your core is no good, Jack, I think that they tell you like working really hard on your calves and like wrists and stuff is not going to help, I think is the more calf.

E (22:34)

That's what they say.

D (22:34)

I'm all calf.

C (22:36)

But in this case, though, our comment was that when we take on board the forecast from our colleagues in research in the different asset classes and regions, the expectation from our colleagues is that a 60:40 basket US equities and treasuries after inflation might net you something like 1% next year in total. Nothing to write home about. And it's possible that we get something different Markets are uncertain. But the point is that when large cap equities are, let's just say, fairly valued, if not outright expensive, Treasuries are enduring one of the longest, largest drawdowns in history, you know, since 2022. And the expectations are, are getting tricky, this seems like an ideal time, especially the changes that we saw in 2025 in which investing broadly where you find good opportunities seems like a smart way to go. So that satellite core approach has never been easier, whether it's through ETFs, through different baskets or other products. There's a few places that have performed really well this year we think can continue. International small stocks, especially with the value tilt, have done incredibly well.

E (23:40)

It's kind of the opposite. It's the exact opposite of what everyone is obsessing on. Everybody's looking at large cap growth, U.S. and so you're saying small cap, overseas value.

C (23:52)

Yeah, small cap, overseas value. It's literally the mirror image. I mean, I maybe date myself a little, but there was an old episode of Seinfeld where George realized how terrible his life was going and he said maybe if I should just do the opposite of what I think I normally ought to do, my life will go well. And it, and it does in this case, you know, the large cap growth is doing really well in the US but you can also do the opposite and do really well is the amazing result with about the same returns and less volatility over the past five years. Hard to believe actually, those facts, but they're true. And less and less correlated to large cap growth than they've ever been before. A lot of that has to do with the success of corporate reforms in Japan and a few other places. I would not take it as a wholesale endorsement of buying developed markets around the world willy nilly. I think the small and value components in these in tactical regions are really important. But there's some funds that do that work for you. I think that's an attractive place to be and it certainly has been the past five years. We mentioned quality and that's a US story still in the US in fixed income, we think it's been a great time to be diversified into credit sectors and places that are not part of most fixed income benchmarks. Things like emerging market debt, fallen angel, high yield, corporate bond funds have performed well and we think those can continue to perform well next year. Even if the very top of the market gets a bit uncertain. The balance sheets of many of these companies and countries are in a place that should produce some meaningful returns above the typical fixed income benchmark. That's certainly been the case in our work over the past few years.

E (25:21)

I think that that unlocks the mysteries of the universe here for me. With regard to quality, it's most helpful. Is there anything I've neglected to ask you on the subject of either quality investing or different ways people can augment their S&P 500 fund or other satellite positions they should hold? Anything else on this subject that you want listeners to know?

C (25:45)

Two other things I would like to Mention, so many of us are focused on equities for good reason, and on hedges or balances from fixed income, again for a good reason. I think that the two other pieces that we hear a lot from investors these days that have become so important are major themes and also real assets. Everyone knows that gold has been an incredible run. I think that the upside, not just for gold, but for real assets generally, whether it's through direct sort of commodity trend following strategies, through the equity of commodity companies or other different investment vehicles, is going to be really important in the years to come. Even if inflation cools in 2026, even if the Fed can cut interest rates and so on and so forth. And we think that they will. Having a portfolio that's robust against risk of inflation, of big moves in currencies, and these other other risk factors that have been off the radar for so many investors for the past 20 years, we think it's going to be incredibly important. So there's again, lots of products to get at this. But I think the main thing when it comes to real assets and commodities is to have a. Not a buy and hold static index, but something that's a bit more dynamic. You know, if you think about the s and P500 in 1970, I don't know what the weight to like at and T was. I think it was probably really large, much larger than it, you know, is today. Same thing's true in commodities. The kinds of commodity indexes that have had static weights for decades have underperformed in a really unhelpful way. There's a newer generation that are more dynamic and some products that are linked to those that have actually given a great result in recent years. Thematics as well, whether it's artificial intelligence or nuclear power or industrialization reindustrialization on shoring, you have to be careful you don't accidentally double up on exposure. But some of these thematic approaches have performed incredibly well and been effective, not just for returns, but also as diversifiers. As many different governments and countries around the world think differently than they have in recent decades about what kind of economy that they want to support. I think that making sure our portfolio is positioned to capture those changes is going to be really valuable in a way that really wasn't necessary for a lot of investors for the past couple decades. As the world changes, we try to change with it. And in our work when it comes to asset allocation and where to put new money to work, I think there's a big range of opportunities that really weren't on the menu for quite a long time but look really attractive today.

D (28:09)

Thank you Jared. I promise you some ETFs and stocks at the end, when Jared talks about companies with high free cash flow as a percentage of enterprise values, those companies outperforming over decades. That is most similar to the methodology of an ETF called PACER US Cash Cows 100. The ticker there is Cowz. The problem is that fund has a big value tilt and so it has not been immune to the underperformance of value stocks over the past decade. Done well over the past 30 years, not as well over the past 10. One of Jared's top recommendations for quality ETFs is something called Victory Shares Free Cash Flow. The ticker there is Vflo and that also screens for free cash flow yield, but then it runs a secondary screen for earnings and sales growth trends. That fund was only launched two years ago and it was recently running a few points ahead of the S&P 500. The cash cows portfolio that went recently for an average of 15 times earnings. The Victory shares portfolio that went for 14 times earnings. Investors can also screen for their own stocks. I ran a screen recently for companies with high free cash yield while keeping an eye out for healthy returns on equity and also any recent analyst upgrades. The stocks I came up with are att, Chevron, Deckers, Outdoor, Expedia Group, General Motors, Merck and Omnicom Group. You can read more in that Barron's cover story about what's like about each of those stocks in the view of analysts who have recently upgraded them. And that's quality stocks. I think we're done. Stay hydrated out there. Don't forget to cool down. This was a workout. Okay, I want to thank Jared Woodard from B of A securities and thank you all for listening. Alexis Moore is our producer. If you have a question you'd like played and answered on the podcast, send it in. It could be in a future episode. Just use the Voice Memo app on your phone. Send it to jack.howe h o u g h@barrons.com you can subscribe to the podcast on Apple Podcasts, Spotify or wherever you listen to podcasts. And if you listen on Apple, go ahead and write us a review. See you next week.