Quality has outperformed growth and value over the long term and captures less of the downside when markets are weak. Discover below how you can access and incorporate high-quality companies into your portfolio.
Our analysis of performance shows that quality stocks have consistently outperformed both growth and value stocks over the long term. Moreover, quality exhibits defensive characteristics that can be valuable to investors in periods of heightened volatility. In particular, our research highlights that high-quality companies capture less of the downside in weak markets than growth or value companies, and that this trend has persisted across multiple periods. The outperformance of quality in such periods clearly demonstrates investors' ‘flight to quality' when markets are volatile.
Even though quality has consistently outperformed growth and value over the long term, it has been a less popular basis for investment than the other two factors. Why? One reason for the continuing preference for growth and value may be that these concepts are better understood by investors. There is also greater consensus as to how to define and measure growth and value.
It's a different matter with quality. While it's relatively easy to recognise companies at the extremes of the quality spectrum, there is no single investment definition of the concept of quality. Different investors define quality differently.
Our analysis shows that there are common traits which can be used to define quality. These include high returns and margins, appropriate leverage, and consistent dividends and payout ratios. Quality companies typically exhibit these common characteristics irrespective of their value or growth orientation.
When executing a quality-based investment strategy, we examine a broader range of elements to make a bespoke assessment of quality. In addition to the accounting metrics above, we examine other measures including environmental, social and governance (‘ESG') factors such as staff turnover, board diversity and independence and overall ESG performance.
We have also observed that quality correlates with growth and value at different times in the economic cycle. As a result, we complement our understanding of quality by using additional models of growth and value.
We believe quality investments can be found across the market capitalisation spectrum because companies with high and stable profits, low volatility and conservative capital practices are less likely to go bankrupt.
Such high-quality stocks typically command a premium over low-quality stocks because of their better and more sustainable business models. Low-quality stocks are cheap for a reason. Our task as investors is to filter out lower-quality stocks and identify true quality.
To help us rank companies by quality, we deconstructed quality into four factors: profitability, persistence, protection and people.
Profitability is crucial to a firm's success. Measures such as operating margin, return on assets and return on equity assess how efficiently firms generate profits from their equity and assets. Operating margin measures how effectively they convert revenues to profits.
Our research shows that profitability measures of quality companies are higher, more predictable and remain more stable over time. These firms appear to have some form of sustainable competitive advantage over the long term.
Quality companies tend to have appropriate - not necessarily low - leverage for their business models. They consistently outperform companies with inappropriate levels of debt and are able to invest excess cash flows to fuel growth, fund acquisitions, pay down debt and return capital to shareholders.
The capital structure of a business is an important determinant of quality since management directly controls capital allocation decisions. For example, consistent dividends are a reliable indicator of investment return given they are paid from real cash earnings. Buybacks are often a tax-efficient way of returning cash to shareholders.
Our index-beating approach to quality investing
To translate our research on quality into a consistent and scalable investment strategy, we created our own definition and index of quality that we apply using both quantitative and fundamental investment techniques. Our approach provides a consistent lens through which we analyse investments and it ensures we focus on investing in safe, profitable and well-managed companies.
The validity of our quality investing strategy can be tested by comparing the performance of our approach with the MSCI World Quality Index (USD). This comparison shows that our proprietary quality index has consistently outperformed the MSCI quality benchmark over a 20-year period*.
*Source: Quality investing - How to outperform growth and value long term, Oct 2021.
No part of this article may be reproduced without written permission. It has been prepared by Davy Global Fund Management based on publicly available information, internally developed data and other sources believed to be reliable. It is not comprehensive and is strictly for information purposes only. It is not an offer or invitation to invest, nor is it advice in relation to any investment. Past performance is not a reliable guide to future performance. The value of investments can fall as well as rise. Davy Global Fund Management Limited, trading as Davy Global Fund Management, is regulated by the Central Bank of Ireland.