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The chase for quality growth: When the going gets tough, the tough keep growing

06 September 2022

Darius McDermott explains why quality-growth fund managers are in high spirits despite the current market environment.

By Darius McDermott,

Chelsea Financial

‘When the going gets tough, the tough keep growing’ is a line a fund manager recently used when extolling the virtues of quality-growth companies in what is likely to be a very uncertain economic climate in the next few months.

Talk of a potential recession has changed to how deep it will be – the days of growth at any price seem a distant memory.

I sometimes feel the notion of quality-growth investing gets lost in the growth and value debate. Despite outperforming both styles over the long term, it could be argued that it is simply harder for investors to understand quality as an investment style.

In a nutshell, these companies tend to have barriers to entry, are led by strong management teams, maintain strong balance sheets, and exhibit the potential to maintain pricing power.

Quality exhibits defensive characteristics that can be valuable to investors in periods of heightened volatility – for me, this translates into an ability not only to continue to grow in these times, but also take advantage of opportunities in their market/sector.

Of course, these stocks are not immune to market shocks – but what history shows is the characteristics these companies display often results in them bouncing back quickly.

For example, although the MSCI ACWI Quality Index saw a maximum drawdown of 50% during the great financial crisis (versus 58.4% for the MSCI ACWI Index in general), it took around half the amount of time to recover those losses (778 days versus 1,529 days).

Quality also bounced back quicker in other, more recent, examples such as the European debt crisis, China’s ‘hard landing’ and Covid-19.

But the start of 2022 was something of an anomaly – with quality and growth both recording losses as we went into in a recovery mode where people wanted cyclical/value stocks. Year-to-date, the MSCI World Quality Index is down 9%, while the MSCI World Value is up 4.4%.

But there’s now an argument this has created an opportunity for quality-growth stocks as investors start to recognise the benefits of these companies with the potential to keep growing in a recessionary environment.

Abrdn UK Mid Cap Equity fund manager Abby Glennie says the market was slow to transition to companies that continued to deliver sustainable growth at the start of this year, but this has begun to change.

A research note from Marlborough supports this, stating that “we have started to see more positive share price moves in recent weeks as commodity costs have started to fall and there are early signs that the labour market could be cooling off”.

“The hope is this feeds through to lower inflation and less pressure to raise rates – benefitting quality-growth companies”.

Glennie says the strong will get stronger and we will see more consolidation – to the benefit of these quality-growth names. The retail sector is a good example, with Glennie citing “lacklustre business models and high leverage as well as concerns consumer demand can fall away quickly”.

An outlier to this is Watches of Switzerland. Glennie says this is a business with great visibility, while supply and demand is also in their favour as people want more watches than there are available. It is also growing in Europe and the US.

“Watches of Switzerland is the partner of choice for other brands. Take Rolex, because they have no interest in selling watches themselves – they want Watches of Switzerland to do this for them – and they will get more than their share of the allocation as a result. Strong demand means they can also pass on inflation.”

Inflation in the watch market stands at 4% but the firm has passed on 7% to customers in 2022.

Murray Income Trust manager Charles Luke says he is also seeing plenty of companies reporting strong earnings figures, giving optimistic forward guidance, but where the share prices have been hit hard anyway.

A good example is Dechra Pharmaceuticals, a firm whose share price fell more than 20% in the first quarter of the year. Luke says at the same time, Dechra’s update to the market showed expectations of future earnings have risen and the company has issued an upbeat outlook for the year ahead, despite the well-flagged headwinds to economic growth.

Rathbone Strategic Growth Portfolio manager David Coombs says he has been adding quality-growth names since May. He says some still look expensive but feels there is no rush to add as he expects at least three to six months of negative news flow from here, leading to days where markets are extremely volatile.

He says: “I’d use Apple as an example of a name we’ve added for the first time. The valuation fell below that of LVMH and that was a trigger for us. While all the FAANGs certainly don’t fit into the quality-growth bucket, I think the market is starting to realise Apple is a quality-growth stock. For me it is more of a luxury retail business, than a tech company.”

It has taken the market some time to adjust to the changing environment, but there is a strong case to suggest quality-growth companies will gain significant traction as investors look for security in the uncertain times ahead.

Darius McDermott is managing director at Chelsea Financial Services. The views expressed above should not be taken as investment advice.

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