- Tom Hancock runs the $8.1 billion GMO Quality fund, which has beaten 99% of its peers for 10 years.
- Hancock adopts a strategy that involves quant research, quality assessment, and stock analysis.
- He breaks down the three buckets of stocks in his fund and shares four high-quality picks.
In another sign of the economic reopening sweeping through markets, Netflix (NFLX) opened almost 8% lower on Wednesday after the streaming giant reported a huge subscriber miss the day before.
With 75 million Americans fully vaccinated, the desire to go outside has not only hurt Netflix but also other stay-at-home darlings including Zoom (ZM) and Peloton (PTON), which have dropped 10% and 34% respectively this year.
While some investors are grappling with the dawning realization that high-growth stocks cannot keep soaring forever, others have rotated into cyclical value stocks for a recovery play. But it doesn’t have to be one or the other.
Quality stocks, which tend to be enduring businesses delivering long-term growth at a reasonable price, appear to straddle the best of both worlds, according to portfolio manager Tom Hancock, who co-runs the $8.1 billion GMO Quality fund.
“If I were to sum up ‘quality’ in one word, it would be relevance,” he said in an interview. “These are companies that are going to be relevant five or 10 years from now because they will keep up with their competitions and have reasonably good capital deployment by management.”
How to identify high-quality stocks
When it comes to stocks, Hancock knows how to separate the wheat from the chaff. His fund has beaten 99% of its peers to deliver a 10-year trailing return of 15.44% on an annualized basis, according to Morningstar data.
The computer science Ph.D.-turned investor starts with a quantitative screening that homes in on companies with a high level of return on capital and strong balance sheets.
Having narrowed down their universe of stocks, Hancock and his team will investigate their fundamentals through a vetting process, which aims to assess the business quality of these companies and gauge whether they will be able to keep up with past performance.
After nailing down the potential growth of selected companies, his team will then build a discounted cash flow valuation modeling to come up with a fair price for these stocks and proceed to buy the cheaper ones.
"Ideally, what we'd like to buy is a company that we feel very confident about five to 10 years from now, but there's something quirky going on in the short term that is keeping investors away from it," he said. "So it's temporarily at somewhat of a depressed price."
3 buckets of stocks and 4 top picks
Hancock mainly invests in three baskets of stocks that consist of (1) growth-oriented tech stocks with reasonable valuations, (2) back-to-normal stocks of high-quality businesses that are temporarily depressed, and (3) healthcare stocks that are long-term secular growth stories.
In the tech basket, Hancock is bullish on semiconductors, which have seen huge demand as a global chip shortage continues to halt auto productions. His top pick in the basket is Taiwan Semiconductor Manufacturing (TSMC), the world's largest semiconductor foundry.
"This is a way to play all the big megatrends without having to necessarily pick winners because this company is kind of a supplier to everybody," he said. "And you're getting it at a much more attractive valuation than if you buy AMD or Nvidia."
In the back-to-normal basket, Hancock likes the British catering company Compass Group (CMPGF), whose main business is in running the kitchens at corporate campuses and universities but it also hosts sporting events, etc.
"Their stock price was understandably hammered during the Covid-19 pandemic and it hasn't recovered," he said. "But we think we're turning the corner on the crisis, people will go back and interact with each other and their business will recover."
In the healthcare basket, Hancock is positive on managed care companies and the big insurers. His biggest position from this theme is UnitedHealth Group (UNH).
"There's always this little bit of overhang of regulation," he said. "But if you just look at the growth rates, the price-to-earnings multiples these companies are trading at, and the natural barriers to entry they have because it's such a scale business, you'd have to really love them."
Hancock and his team are always looking for new opportunities to scoop up for the portfolio.
One of the companies he has bought this year is French aircraft manufacturer Safran (SAFRF), whose stock was beaten down by the pandemic-era travel restrictions and has still not fully recovered.
"The company has a razor blade model where they don't make that much money on the engine, they make it on the service after the fact, which is a great sticking business," he said. "But it is dependent on air miles flown, so obviously when that's down, they're not doing as well as they would normally, so we thought that was a great time to enter."