With markets firmly in the latter stages of the market cycle, investors are increasingly seeking out strategies that should withstand the potential challenges that are associated with the late cycle.
Some of the most popular equity strategies with investors have been those focused on quality stocks such as Fundsmith Equity and Lindsell Train Global Equity.
Indeed, the style has outperformed in the benign conditions of the past decade, with the MSCI World Quality index up by 307.78 per cent, outperforming both the growth and value styles.
Performance of indices over 10yrs
Source: FE Analytics
However, investors feel there is further room for outperformance. A net 54 per cent of respondents to the latest Bank of America Merrill Lynch Global Fund Manager Survey expect high-quality stocks to outperform low-quality stocks over the next 12 months.
Quality as an investment style is definitely back, said Aneeka Gupta, associate director of research at investment firm WisdomTree.
“From January to April, we saw very strong inflows into equities, as investors enjoyed a free ride, on the hopes of a successful trade deal,” she said. “Now that this has not happened, we’re starting to see investors being very selective and going for quality names. These are stocks or equities that have been filtered for a high return on assets, a high return on equity, and a strong forward-looking earnings growth.”
She explained that in 2017 and early 2018 when the market was performing strongly, the style factor that garnered the most inflows was momentum.
“Now we’ve moved away from momentum to quality,” she said. “Investors are definitely looking beyond market cap, weighed indices. They’re looking for a strategy that could potentially outperform the benchmark in a more volatile environment.”
Late-cycle investing requires a significantly different approach from what has prevailed over the last 10 years. During much of the past decade, low starting valuations combined with central bank support and continued globalisation boosted asset prices.
Many of these trends are now reversing, and in a typical late cycle environment – when volatility normally increases – investors need to be more selective and prudent.
“Indeed, we’re starting to see investors being very picky and going for quality businesses,” Gupta said. “Now, quality definitely resonates.”
“Quality investing is about making investment decisions that take account of the quality of a company or, in the case of asset allocation, a country,” added Peter Elston, chief investment officer at Seneca Investment Managers. “We see quality as being synonymous with reliability.”
The Seneca investment chief said investors hunting for quality need to ask the following questions: Is a company’s brand associated with reliable products? Does it have a reliable balance sheet and returns on capital that have over time been stable and reasonably high? In the case of countries, what is the long-term record of financial market returns? Do a government’s finances look stretched? Does a country have big external deficits?
The basic idea behind quality investing, he said, “is that high quality is a competitive edge that can last a very long time and thus something that is not sufficiently discounted in share prices”.
“In other words,” he said, “there is systematic undervaluation of quality.”
While they may share similar traits, quality investing should be viewed independently from both the value and growth styles. The value investor is mainly concerned with valuation, and the growth investor’s primary focus is earnings forecasts.
The quality investor, on the other hand, chooses stocks whose earnings growth are rooted in the company’s fundamentals and whose price is justified.
Most quality investors would probably agree with Warren Buffet’s famous statement: “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Company fundamentals are secondary for the value investor, who places greater trust in certain metrics such as price-to-earnings (P/E) ratio and price-to-book (P/B) ratio.
However, for Seneca’s Elston (pictured), the distinction is more apparent than real.
“From our perspective, quality and value are one and the same,” he said. “Quality is about the reliability of a long-term income stream, value is about valuing it.”
The growth investor focuses on earnings expansion and high profit expectations, regardless of valuation. 
Elston said it’s far easier for a company to increase revenues in the shorter term but not so easy for the growth over the longer term to be profitable.
Ultimately, a quality portfolio may include stocks with both value and growth attributes.
“After all, it’s a competitive world out there,” he said. “While there are and have been some very successful growth investors – Sir John Templeton perhaps being the best known – we prefer to focus on what we can measure, such as brand recognition and valuation of existing income streams.”
In the view of Tracy Zhao, investment research analyst at The Share Centre, quality investing is multi-faceted and can be applied to many different asset types.
“Investments of this kind should be able to sustain their competitive advantage over lower-quality investments for longer,” she said.
When searching for quality funds, Zhao looks for four characteristics: an experienced and committed fund manager, a strategy and processes the manager is well versed in, returns in line with the risk profile, and a proven track record.
She highlighted two equity funds and one investment trust that “tick the boxes and have been delivering steady results over the long term”.
Heading Zhao’s list of “quality investments” is the First State Global Listed Infrastructure fund, which targets income and capital growth through investing in infrastructure companies around the world.
The £1.7bn five FE Crown-rated fund has been steered through rising and falling markets by Peter Meany since its launch in 2007. It was joined by Andrew Greenup in 2011.
As the below chart shows, over 10 years the fund has made a total return of 194.14 per cent compared with a gain of 128.81 per cent for the average IA Global peer and a 219.23 per cent return for the FTSE Global Core Infrastructure 50/50 index. It has an ongoing charges figure (OCF) of 0.78 per cent and a yield of 2.92 per cent.
Performance of fund vs sector & benchmark over 10yrs
Source: FE Analytics
Zhao’s next fund is the £1.4bn Man GLG Continental European Growth fund, managed by Rory Powe, which targets above-average, long-term capital growth.
The portfolio combines ’established leaders’ that have a clear three-to-five-year expansion path in terms of earnings and free cash flow; and ‘emerging winners’ that are in the vanguard of new or existing markets and have demonstrated clear competitive advantages.
Since Powe joined the fund in October 2014, it has made a total return of 112.98 per cent compared with a 54.33 per cent gain for the FTSE Europe ex UK index and a 48.9 per cent return for the IA Europe Excluding UK sector average. It has an OCF of 0.90 per cent.
Finally, Zhao highlighted RIT Capital Partners headed by Ron Tabbouche, a closed-ended, multi-asset fund which has exhibited an “excellent long-term track record” on delivering growth whilst preserving shareholder capital.
“Investors looking for a risk-averse global trust may well find this a suitable investment,” Zhao said, although she warned it could lag in rising equity markets due to a defensive bias.
The £3.2bn trust has returned 159.25 per cent over 10 years compared with a gain of 85.35 per cent for the average IT Flexible Investment peer.
RIT Capital Partners is 15 per cent geared and has ongoing charges of 0.68 per cent, according to the Association of Investment Companies. It has a yield of 1.6 per cent and trades at a 8.6 per cent premium to net asset value (NAV).