Having dominated for the past decade, the quality style has outperformed its growth and the broader market. Yet, with the longevity of the market cycle under question can quality stocks continue to generate the gains investors have become accustomed to?
As the below chart shows, the MSCI World Quality index has significantly outperformed the broad index and the growth style – which has also been dominant in recent years – over the past decade.
Performance of indices over 10yrs
Source: FE Analytics
However, there are some difficulties in judging performance by such factor-based indices, according to Kepler trust Intelligence’s Thomas McMahon.
The analyst McMahon noted that quality style indices have significant industry and sector exposure.
“The picture is also complicated by the fact [that] ‘quality’ is a hard factor to define, making it crucial to understand the investment process of a manager thoroughly,” he said.
For example, said McMahon, the MSCI World Quality index has a significant overweight to the US – making up about three-quarters on the index – compared with 63.3 per cent for the broad index.
As the US has led the global market higher since the global financial crisis it’s little surprise that the style index has outperformed.
Additionally, the sector weighting for the top-performing technology sector is more than double that of the broad index – 35 per cent to 16.6 per cent.
Nevertheless, the style has performed particularly well in recent years, prompting McMahon to ask whether it is “time to take profits and look elsewhere”.
Maybe not, he suggested.
“In our view, it is important to look at fundamentals rather than worrying about mean reversion, which is merely giving in to the gambler’s fallacy – unless backed up by a reasoned case for prices or values to revert to a historic mean.”
One of the greatest arguments in favour of the style should be enhanced during a downturn given the style’s “strong historic tendency to protect on the downside”.
“In theory, when markets sell-off investors will prefer to hold on to the companies with surer prospects – more secure balance sheets, better profitability, less cyclicality – and sell the more indebted or more economically sensitive ones first,” McMahon explained.
Rolling 10-yr downside risk over 10yrs
Source: FE Analytics
McMahon said the MSCI World Quality index has a long track record of outperformance displaying lower maximum drawdown, lower volatility and lower downside risk than the broad index.
In addition, he said, while the quality index has tended to underperform in the sharpest rallies, these are unlikely to occur in the near future as the low growth, low-rate environment is likely to persist.
“This is conducive to a quality style favouring companies with stable earnings and defendable niches, and those which have earnings that are less dependent on economic growth in the wider economy,” he said.
“The likeliest way out of this state is a recession rather than an inflationary tear at the moment, and in that case we would expect quality to outperform, in line with its impressive record on the downside.”
Furthermore, the Kepler analyst said there are other factors that may favour the quality style in the coming years involving the impact of regulation and a “sea change” in politics.
“In our view, the shift towards greater regulation favours companies with deep economic moats, companies often classified as ‘quality’,” he said.
While the index has proved more resilient in downturns, the investment trust analyst believe that a passive play could expose investors to some risks.
A passive investment – based on the MSCI World Quality index – would saddle investors with a large US weighting, particularly given its tendency to lead markets down, as well as up.
“A high weighting to the US could be a significant headwind should the current bearish sentiment towards the US turn out to be warranted, and this could counteract the historic tendency of the quality index to outperform on the downside,” he explained.
It would also mean taking on significant tech exposure, which is currently trading at a premium to the overall market in the US, which could cause further worry, according to McMahon.
“In our view, these are the sorts of risks which justify paying an active manager to assess and deal with,” he explained. “None of these issues will appear in the formulas used to generate a passive quality portfolio, and no situation quite like today’s has been experienced in the past.”
As such, the analyst said active managers with a quality style might offer better returns as long as investors are selective.
“In our view, if you can find managers who focus on these metrics that have been proven to work, then you still stand to do well out of investing in quality trusts,” he said.
“In fact, the current economic environment could continue to favour quality over growth and value.”
One such trust – and one well-known for its quality style – is Finsbury Growth & Income Trust overseen by FE Alpha Manager Nick Train.
“Nick Train’s portfolio has generated 18.8 per cent a year in NAV [net asset value] total return terms over the past decade,” said the Kepler analyst. “He has done so with remarkably consistent outperformance.”
Train looks for companies across the world with brands or other hard-to-replicate assets that ensure they grow faster than the market.
Performance of trusts over 3yrs
Source: FE Analytics
Another example is Terry Smith’s Fundsmith Emerging Equities Trust, which also has a strong quality style albeit with an emerging markets focus.
“Smith places more emphasis on the use of accounting metrics, and looks at return on capital employed and the cash quality and repeatability of earnings,” said the analyst.
“The output is a portfolio with extreme exposure to consumer staples and India. In our view, the relatively narrow focus makes it hard to see the trust as a core emerging markets holding.
“Smith may be proven right in the long run about where the opportunities are, but the track record of the trust so far shows the risks in being concentrated in one geography and sector.