The AI Mania and the Possibility of Steady Profits from Quality Companies

With growing concerns about a bubble driven by artificial intelligence, many investors feel trapped between the optimists—who argue that high stock valuations are justified because AI is the biggest technological revolution so far—and the pessimists, who believe this situation is no different from previous bubbles and that every bubble eventually bursts. The feeling of being trapped is made worse by the lack of alternatives, since gold, bonds, and other safe havens also look expensive.

However, a once-in-a-generation opportunity is emerging in global markets that can deliver strong returns regardless of how the AI mania unfolds. This opportunity lies in quality stocks, especially those trading at relatively low prices. According to MSCI indices, “quality” stocks are defined as companies with high return on equity (ROE), stable earnings growth, and low levels of debt.

Worldwide, only about one-fifth of stocks fall into this category, and over the past three decades they have consistently outperformed the market as a whole, as well as other investment styles such as “growth” or “value.” Because of this, quality stocks are often considered expensive. Today, however, that is not the case.

Over the past year, quality stocks have experienced one of their largest periods of relative underperformance: in developed markets they trail the broader index by almost 10 percentage points, and in emerging markets by a record 17 percentage points.

While average valuations in the global equity market—dominated by the U.S.—are high and trading well above historical levels, the quality segments of these markets are trading below trend. Typically, quality stocks deliver their best results after such (rare) periods of underperformance, making the present moment particularly favorable.

Interestingly, quality stocks are lagging despite significant exposure to major tech companies. Of the “Magnificent Seven” firms driving the spread of AI, five meet the “quality” criteria. Even with names like Alphabet and Microsoft included, the quality stock class is still underperforming because it excludes low-quality stocks that have recently surged due to liquidity and speculation.

Usually, these low-quality stocks are heavily indebted, unprofitable, and volatile, but lately their prices have jumped sharply, driven by retail investors and big expectations for AI. This year, the returns of high-quality U.S. stocks are less than one-seventh of those of “unprofitable tech” companies, which have surged 70%. Fueled by speculative enthusiasm, investors are also ignoring many sectors and countries dominated by quality stocks, including healthcare and consumer goods in developed markets.

Because everything—from equities to gold—seems expensive, some long-term investors are stepping back from markets, arguing that recent price movements are dangerously “irrational.” Others are taking defensive positions, holding large amounts of cash despite its low real return after inflation. However, there is a way to generate reasonable returns in this environment—by buying quality stocks. One way to do this is through “quality” ETFs traded on various exchanges.

The real opportunity right now, however, lies in a portfolio of quality stocks without the most overvalued companies. To identify these potential “hidden gems,” I ranked companies in the U.S., other developed markets, and emerging markets according to the “quality” criteria, refining MSCI’s standard by strengthening profitability metrics and adding revenue-growth indicators. I filtered out companies that were too small, illiquid, prone to volatile price swings, or flagged for questionable practices such as overly generous stock compensation packages. Finally, I conducted a valuation assessment based on free cash flow yield and forward price-to-earnings ratios—effectively excluding the most overvalued Big Tech firms.

The result is a list of about 400 high-quality stocks trading at attractive valuations, including almost 140 in the U.S. and just over 40 Chinese companies listed in Hong Kong. Clusters of such stocks can also be found in the U.K., Brazil, and India. By sector, more than 20% of this undervalued, high-quality group consists of industrial companies, followed by financials and consumer companies.

Focusing on the largest stocks with a market cap above $10 billion, many familiar names appear. The top 30 in each category—U.S., other developed markets, and emerging markets—include Lockheed Martin and CVS Health, Tesco and AstraZeneca, as well as FirstRand and Lenovo. (These examples are representative results, not stocks I own, manage, or necessarily recommend.)

On average, companies in my top-30 lists have a return on equity of 19%, compared to 11% for the market overall. They generate significant cash flow and dividend yields roughly twice as high as the index, with lower volatility. As a group, they have not looked this attractively valued since the early 2000s. They are currently trading at a 30% discount to the market—a gap not seen since the end of the dot-com bubble.

From these low valuation levels, using standard methods of forecasting future returns, this class of quality stocks is expected to deliver an absolute annual return of nearly 15% over the next three years. This significantly outperforms expected returns of other assets and—perhaps most importantly—does not require predicting whether or when the AI mania will end.