As speculative trends ease, high-quality stocks may prove attractiveFebruary 25, 2021By Joe Hudepohl, CFAPortfolio Manager and Managing Director, Atlanta Capital and Charles B. Reed, CFAPortfolio Manager and Managing Director, Atlanta CapitalAtlanta - Throughout 2020 and so far this year, low-quality stocks have significantly outperformed their high-quality counterparts. Within several equity benchmarks, the differential has been significant. In the Russell 1000® Growth Index, for example, low-quality stocks outpaced high quality by 29% in 2020 — the largest performance gap in the history of the index, dating back to 1984. Similar to 1999 and early 2000, primarily large-cap, technology-oriented names have dominated equity index returns and we've seen a lot of "animal spirits" at work. Speculation driving some marketsIn our opinion, risk-seeking has been off the charts. Fundamentals (i.e., earnings) seem to have been of little importance to market participants lately. Instead, investors appear more drawn to special-purpose acquisition companies (SPACs), initial public offerings (IPOs), stocks with high short-interest levels, and perceived pandemic winners (despite many not being profitable).Interestingly, over the trailing 12 months ending February 11, 2021, only 41% of companies with a market capitalization over $250 million had positive earnings, according to Bloomberg. And, despite negative sales and earnings growth, the S&P 500 Index has gained over 18% during this one-year period. This is one of many indications that markets are being propelled higher by speculation. While periods of low-quality outperformance are certainly frustrating, we remind ourselves that we have seen these types of markets before. Periods of high-risk speculation, like we've seen recently with Reddit investors in several small-cap stocks, and in the market more broadly, are often short in duration and subject to high volatility.Underappreciated risks of todayWithin the growth universe, we view concentration and valuation risks to be especially high. As of December 31, approximately 36% of the Russell 1000 Growth Index was concentrated in its top five stocks— Microsoft, Apple, Amazon, Facebook and Alphabet. The information technology sector alone accounted for 45% of the index — as distorted as it has been since the 2000 tech-bubble era. If we take into consideration some of the internet stocks that were shifted out of technology and re-categorized into communication services in 2018, this large-cap growth index looks to us like a technology sector fund — and not adequately diversified.In the mid-cap space, many software stocks are trading at not 20, 30 or 40 times earnings, but at 20, 30, 40 or 50 times sales — and in some cases, even higher. It's been a risk-on market and with the valuations being afforded to some companies, we are seeing a lot of stock issuance and IPOs, as mentioned earlier.Equity valuations more broadly appear expensive to us. The popular valuation metric of total market capitalization to gross domestic product (GDP) has reached its all-time high, at 206%. For context, it was as high as 175% of GDP leading up to 2000, and 140% prior to the 2008 financial crisis. This is one of several measurements that in our view signals now is a time for caution. Where do we go from here?We don't know when these trends may reverse, but we believe that exposure to high-quality companies is more important than ever, as speculative excesses are seemingly continuing to build. The equity market appears mostly fully valued, with the S&P 500 Index trading at around 22x forward earnings, a touch below levels seen during the dot-com bubble. This leads to questions of where opportunities exist now. We are optimistic about the future prospects of consumer-related names held in our portfolios that have been punished in the short term by the pandemic and unemployment. Additionally, we see particular value in the life sciences, where companies are less directly affected by the vaccine race, as well the "digital wallet," where players are benefiting from the shift to e-payments. Our strategies invest strictly in high-quality stocks and have high active shares. These traits, along with others, make us optimistic that our portfolios are well positioned if the market were to shift. Higher-quality companies typically have consistent earnings, strong balance sheets, significant free-cash-flow generation, growing revenues and meaningful competitive advantages, whereas the opposite is true for their lower-quality counterparts. Historically, high-quality equities have outperformed over full market cycles. Looking ahead, it's not only what we own that makes us excited, but it's also about what we don't own — where we see valuations being so stretched. As capital comes out of those expensive names, we expect that investors will likely turn to some of the high-quality stocks that are owned in our portfolios. Bottom Line: We think it's an opportune time for investors to allocate to an active, high-quality strategy — one that seeks to protect capital during declines, while still participating in the long-term benefits of equity investing.Index definitions:Russell 1000® Growth Index is an unmanaged index of U.S. large-cap growth stocks.S&P 500® Index is an unmanaged index of large-cap stocks commonly used as a measure of U.S. stock market performance.