Case for Quality
Investing in high-quality businesses is a time-tested approach that enables investors to increase their chances of capturing what have been historically stronger risk-adjusted returns. This is possible because high-quality companies tend to experience lower volatility and greater strength and consistency in returns over a market cycle, including the most difficult times.
In the years coming off of the Great Recession, lower-quality companies had a relatively strong run in part because they typically have the most to gain from improving credit markets and low interest rates.1 However, a move toward normalization of monetary policy is in full swing, as we’ve seen consistent interest-rate increases by the U.S. Federal Reserve in 2018. That there is a move away from days of artificially low interest rates is clear. This is likely to benefit higher-quality businesses that are less leveraged and less dependent on the credit markets, and also have the financial reserves to continue self-funding their growth opportunities.
Quality investing looks beyond the traditional style boxes of market capitalization (large, mid, and small) and investment style (value, core, and growth). It is a more rigorous investment approach that employs in-depth, bottom-up qualitative and quantitative research, which seeks to identify companies with outstanding financial and business characteristics. The long-term advantages of a quality-focused portfolio can be seen below:
Over this time frame, a $1 million investment in high-quality stocks within the Russell 3000 Index would have grown to about $6.3 million, compared with $4.8 million had the money been invested in the broader Russell 3000 Index, and $1.6 million had the money been dedicated to lower-quality stocks that in certain segments of market cycles can outperform.2
The market often favors low-quality stocks in generally upbeat markets that drive stock rallies. As long-term investors know, rallies are bound to recede, as we’ve seen what has occurred in the broad stock market so far through 2018. And at times, the market may have a bias against quality. In the graph below, positive-sloping segments of the dark green line indicate outperformance by high-quality stocks over the Russell 3000 Index, whereas negative-sloping portions represent quality underperformance. Similarly, the orange line indicates the relationship between low-quality stocks and the Russell 3000 Index.
There may be short-term fluctuations in the market’s bias toward quality, but it is clear that quality stocks over the long term have outperformed. Markets are too complex and dynamic for anyone to be able reliably predict future price movements and thereby time the market as it transitions from a low-quality bias to a high-quality bias and vice versa.
A consistent focus on high-quality businesses would serve an investment portfolio well as the characteristics of those individual investments are strong, competitive and sustainable.
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1. High-quality stocks are defined as those within the index that have a return on equity (ROE) greater than 15% and a ratio of debt-to-assets below 30%. Low-quality stocks are defined as those within the index that have ROE less than 5% and a debt-to-assets ratio above 40%.
2. Data from mid-2013 to mid-2014 showing better performance of debt-laden companies that have low returns on equity.