More and more investors turned to quality in 2023 as interest rates went higher amid the inflation storm. The iShares MSCI USA Quality Factor ETF gained 29% in 2023, beating the S&P 500 returns of 24%. The rise of Magnificent Seven stocks like Microsoft Corp (NASDAQ:MSFT), Meta Platforms Inc (NASDAQ:META) and Apple Inc (NASDAQ:AAPL) was a sign of the market's concentration in quality as investors flocked to companies with strong balance sheets and fundamentals. But what exactly are quality stocks? Billionaire Cliff Asness, Andrea Frazzini, and Lasse H. Pedersen wrote a research paper in 2013 titled "Quality Minus Junk" in which they defined quality stocks as follows:
"We define a quality security as one that has characteristics that, all-else-equal, an investor should be willing to pay a higher price for: stocks that are safe, profitable, growing, and well managed. High quality stocks do have higher prices on average, but not by a very large margin. Perhaps because of this puzzlingly modest impact of quality on price, high-quality stocks have high risk-adjusted returns. Indeed, a quality-minus-junk (QMJ) factor that goes long high-quality stocks and shorts low-quality stocks earns significant risk-adjusted returns in the U.S. and globally across 24 countries. The price of quality – i.e., how much investors pay extra for higher quality stocks – varies over time, reaching a low during the internet bubble."
While the market is expecting rate cuts this year, rising geopolitical tensions and a persistent inflation is keeping the demand for quality stocks higher. Almost all notable investment firms including Morgan Stanley, Wells Fargo, JPMorgan and Goldman Sachs recommended investors to buy high quality names for 2024. Why? High-quality stocks tend to perform better when growth is slowing down. A latest Wall Street Journal report quoted data from UBS which said the MSCI ACWI Quality Index has beaten the MSCI’s global index by 1 percentage point over six-month periods in which the economic growth slowed.
The research paper from Cliff Asness we mentioned earlier also talked about the returns of quality stocks during troubled times:
"Our results present a puzzle for asset pricing. They are consistent with quality stocks being underpriced and junk stocks overpriced or, alternatively, with quality stocks being riskier than junk stocks. However, while one can never rule out a risk explanation for the high return of quality stocks, we are unable to identify this risk; in anything, we find evidence of the opposite. We show that quality stocks are low beta and, rather than exhibiting crash risk, if anything they benefit from “flight to quality,” that is, they have a tendency to perform well during periods of extreme market distress. These findings present a challenge for risk-based explanations where bad states of the world are negatively correlated to extreme return realizations of the market factor. Finally, we show that the price of quality varies over time, generating a time-varying expected return on quality-minus-junk portfolios: a low price of quality predicts a high future return of quality stocks relative to junk stocks."
Most Undervalued Quality Stocks To Buy According To Hedge Funds
For this article we first listed down all holdings of the Vanguard U.S. Quality Factor ETF with PE ratios less than 30 as of January 26. From these stocks we picked 16 companies with the highest number of hedge fund investors. Why hedge funds? Hedge funds’ top 10 consensus stock picks outperformed the S&P 500 Index by more than 140 percentage points over the last 10 years (see the details here).
Transportation services company Landstar System Inc. (NASDAQ:LSTR) is among the best undervalued quality stocks to buy according to hedge funds. In October Landstar System Inc. (NASDAQ:LSTR) posted Q3 results. GAAP EPS in the period came in at $1.71, beating estimates by $0.01.
With a dividend yield of 2% and a PE ratio of 13, insurance and financial solutions company American International Group Inc (NYSE:AIG) is among the best undervalued quality stocks to buy according to hedge funds.
Insider Monkey's database of 910 hedge funds shows that 42 hedge funds had stakes in American International Group Inc (NYSE:AIG).
Diamond Hill Large Cap Strategy made the following comment about American International Group, Inc. (NYSE:AIG) in its Q3 2023 investor letter:
“Insurance company American International Group, Inc. (NYSE:AIG) was also among our top contributors. The company’s most recent operating results outperformed expectations, as it reported robust earnings with improving underwriting margins in the property and casualty business. AIG’s strategic initiatives also added to the positive sentiment. The company made further progress in separating its Life & Retirement unit by selling additional shares via a secondary offering. Furthermore, AIG announced the sale of its reinsurance business to RenaissanceRe at an attractive valuation, a move that will further reduce volatility in AIG’s continuing operations.”
Microchip Technology Inc (NASDAQ:MCHP) is one of the best undervalued quality stocks to buy according to hedge funds.
Earlier this month, Wolfe Research upgraded Microchip Technology Inc (NASDAQ:MCHP) along with some other semiconductor stocks as it becomes "incrementally more bullish" on analog circuits.
"We stayed neutral on analog for too long this cycle, since stocks bottomed an unprecedented full year before fundamentals began to deteriorate," Wolfe Research analyst Chris Caso said in a note.
Here is what Weitz Conservative Allocation Fund has to say about Microchip Technology Incorporated (NASDAQ:MCHP) in its Q3 2023 investor letter:
“We added a new position in Microchip Technology, Inc., (NASDAQ:MCHP) to the Fund during the quarter. Microchip is a leading provider of mixed signal microcontrollers and analog semiconductors to a broad range of industrial, data center, automotive, communication and consumer appliance customers. The company enjoys favorable product characteristics that help drive strong profitability, and it benefits from several long-wave demand tailwinds such as electronification, automation, and growth in data communications. While Microchip is not immune from semiconductor cycles, its cash flows have been durable through cycles. The multi-year outlook is solid, and we think the company is poised to further boost per-share value growth through increasing share repurchases at discounted prices.
HR and payroll solutions company Paychex Inc. (NASDAQ:PAYX) ranks 13th in our list of the best undervalued quality stocks to buy according to smart money investors. Earlier this month Paychex Inc. (NASDAQ:PAYX) declared a $0.89 per share dividend, in line with the previous dividend. Paychex Inc.'s (NASDAQ:PAYX) board also approved to buy back up to $400 million of its common stock beginning February 1, 2024 and expiring on May 31, 2027.
“Paychex, Inc. (NASDAQ:PAYX) (3.71% weight in the Fund): While employment growth was strong in 2023, the Fed’s efforts to moderate job growth was successful. Paychex business is driven by the number of employees on the payrolls of its small to medium size business customers. With recession worries percolating all year, the stock was flat on a year to date basis in late October just as the economic outlook began to brighten. As recession worries faded the stock rallied to gains of as much as 13% in the fourth quarter. But in the late December earnings report, the company said that core payroll services growth would be a bit weaker than investors expected. Despite this, the company slightly raised full year earnings guidance as demand for their full service solution that incorporates human resources services beyond payroll improved. The stock finished the quarter up 4.1%.”
In December, Morgan Stanley published a list of 32 stocks with high free cash flow, high earnings per share growth, and an overweight rating in its U.S. Marathon Petroleum Corp (NYSE:MPC) made it to the list.
As of the end of the third quarter of 2023, 48 hedge funds tracked by Insider Monkey had stakes in Marathon Petroleum Corp (NYSE:MPC). The biggest hedge fund stakeholder of Marathon Petroleum Corp (NYSE:MPC) during this period was Paul Singer's Elliott Management which owns a $1.7 billion stake in Marathon Petroleum Corp (NYSE:MPC).
Oppenheimer recently started covering Builders FirstSource with an Outperform rating. Here is what the firm said about Builders FirstSource Inc. (NYSE:BLDR):
“The company has a market-leading position in a fragmented industry and should benefit from our optimistic view of single-family housing starts in 2024. Growth in value-added products increases the amount of revenue tied to services and is a positive for gross margin and returns.”
Over the past one year Builders FirstSource Inc. (NYSE:BLDR) shares have gained about 124%.
In its Q3 2023 investor letter, Bonhoeffer Capital Management stated the following regarding Builders FirstSource, Inc. (NYSE:BLDR):
“Over the past 12 months, interest rates have been increasing, which has reduced the economics of this strategy; but a large spread still exists if assets can be purchased at the right price. Increasing interest rates has affected the returns on public LBO firms. Some firms, like Builders FirstSource, Inc. (NYSE:BLDR) (described below), have reacted to higher interest rates by moderating their use of debt in their expansion plans.
With a dividend yield of 3.7% and a low PE ratio, Gilead Sciences Inc. (NASDAQ:GILD) is a notable member of the Vanguard U.S. Quality Factor ETF portfolio. The stock is up about 3.9% over the past six months.
As of the end of the third quarter of 2023, 55 hedge funds out of the 910 funds tracked by Insider Monkey had stakes in Gilead Sciences Inc. (NASDAQ:GILD). The biggest hedge fund stakeholder of Gilead Sciences Inc. (NASDAQ:GILD) was Cliff Asness's AQR Capital Management which owns a $358 million stake in Gilead Sciences Inc. (NASDAQ:GILD).
In its fourth quarter 2023 investor letter, ClearBridge Dividend Strategy stated the following regarding Gilead Sciences, Inc. (NASDAQ:GILD):
“In the second half of 2023 — as we were selling low-growth, high-multiple stocks and taking advantage of oversold conditions in infrastructure, real estate and utilities — we also found opportunities in overlooked areas of health care. After adding Gilead Sciences, Inc. (NASDAQ:GILD) in the third quarter, we bought AstraZeneca in the fourth quarter. Each of these stocks present distinct investment cases, but both are reasonably valued and have limited patent expiry or pipeline risk. Gilead’s strength comes from its dominant franchise in HIV. It offers lower growth, but it yields nearly 4% and trades at 11x earnings. AstraZeneca possesses a diversified portfolio of pharmaceuticals, which should deliver double-digit earnings growth, yet it trades at just 16x earnings. These stocks were underwritten individually, but collectively we like the idea of increasing our exposure to defensive and growing health care names at below-market multiples.”
US retailer Target Corp (NYSE:TGT) is a key part of the Vanguard U.S. Quality Factor ETF. The stock has a dividend yield of over 3% and had 58 hedge fund investors as of the end of the third quarter of 2023.
Like Microsoft Corp (NASDAQ:MSFT), Meta Platforms Inc (NASDAQ:META) and Apple Inc (NASDAQ:AAPL), hedge funds are also buying Target.
In its fourth quarter 2023 investor letter, ClearBridge Large Cap Growth Strategy stated the following regarding Target Corporation (NYSE:TGT):
“Other meaningful moves during the quarter included additions to cyclical growers we consider early cycle consumer plays: Target Corporation (NYSE:TGT), a position initiated in the third quarter, and Estee Lauder. As earnings start to recover, these stocks and semiconductors tend to be among the first to move. We may be a little early and could see some choppiness in stock prices as job growth and consumer spending cool due to the lagged effects of Fed tightening, but we believe we’re closer to the bottom in terms of economic activity and that both companies, as well as Union Pacific, are well-positioned to benefit as consumer sentiment improves and the economy begins to recover.”
Piper Sandler recently said in a report that Cisco Systems Inc (NASDAQ:CSCO) shares have "reversed" a downtrend and the investment firm expects more upside to the stock.
Piper Sandler mentioned this in its Technical Research report on SMID Momentum. Piper Sandler said:
“We are optimistic about equities with the (SPX), (INDU), and (NDX) hitting record highs, but waning market breadth is a notable concern. We saw some signs of rotation yesterday as SMID-caps began rallying out of their three-week pullbacks.”
Oakmark Fund made the following comment about Cisco Systems, Inc. (NASDAQ:CSCO) in its Q3 2023 investor letter:
“Cisco Systems, Inc. (NASDAQ:CSCO) is the leading networking solutions company. Networking equipment becomes more important as businesses modernize their IT infrastructure, and Cisco is well positioned to capture this demand given its broad portfolio and highly effective go-to-market strategy. Cisco is transitioning away from selling mainly transactional hardware and toward selling more software and subscriptions. This shift is expected to accelerate revenue growth, improve operating margins and build recurring revenue. Despite these notable business improvements, Cisco still trades near a trough valuation relative to the S&P 500 Index. More recently, Cisco announced its intention to acquire Splunk, a leader in security and observability, adding to its already strong position in the increasingly important security market. At a low-teens multiple of our estimate of normalized earnings, Cisco is trading comfortably below our estimate of intrinsic value.”
Bristol-Myers Squibb Co (NYSE:BMY) ranks seventh in our list of the most undervalued quality stocks to buy according to hedge funds. Bristol-Myers has a dividend yield of about 4.8% and its biggest shareholder as of the end of the third quarter of 2023 was John Overdeck and David Siegel's Two Sigma Advisors which owns a $384 million stake.
Out of the 910 funds tracked by Insider Monkey, 65 hedge funds reported owning stakes in Bristol-Myers Squibb Co (NYSE:BMY).
In addition to BMY, hedge funds are also piling into Microsoft Corp (NASDAQ:MSFT), Meta Platforms Inc (NASDAQ:META) and Apple Inc (NASDAQ:AAPL).
Madison Sustainable Equity Fund made the following comment about Bristol-Myers Squibb Company (NYSE:BMY) in its Q3 2023 investor letter:
“During the quarter, we sold our positions in Bristol-Myers Squibb Company (NYSE:BMY) and The Walt Disney Company. We added Texas Instruments as a new position. Bristol-Myers has been dealing with the loss of exclusivity for Revlimid, one of its key products. Although the company is launching new drugs in melanoma, heart failure, and psoriasis it will need additional products to offset the lower revenue in Revlimid.”
Earlier in January, BofA listed its Efficient Growth Index top members for 2023’s fourth quarter in its RIC Report. PepsiCo Inc. (NASDAQ:PEP) was part of the list of stocks mentioned in the report.
With a PE ratio of 27 and a 3% dividend yield, PepsiCo Inc. (NASDAQ:PEP) ranks sixth in our list of the best undervalued quality stocks to buy according to hedge funds. Insider Monkey's proprietary database of 910 funds shows that 65 funds had stakes in PepsiCo Inc. (NASDAQ:PEP) as of the end of the September quarter.
RiverPark Advisors made the following comment about PepsiCo, Inc. (NASDAQ:PEP) in its Q3 2023 investor letter:
“PepsiCo, Inc. (NASDAQ:PEP): PepsiCo is a leading global beverage and snack food company with a portfolio of brands, including Lay’s, Doritos, Cheetos, Gatorade, Pepsi-Cola, Mountain Dew, Quaker and SodaStream. The company, through its operations, authorized bottlers, contract manufacturers and other third parties, makes, markets, distributes and sells a wide variety of beverages and snack foods, serving customers and consumers in more than 200 countries and territories.
