Equity investors face tough choices as they try to build more resilient portfolios in today’s challenging environment. In a world in which economic (or ‘cyclical’) growth may be harder to come by, investors can choose to skew equity exposures toward more defensive companies less sensitive to the ups and downs of business and economic cycles. They may also tilt towards different regions, sectors and equity ‘styles’ (categories of stocks that share similar characteristics and performance patterns).
Stocks can be classified by style (or ‘factor’) in many ways. The most common are in terms of one or more measures of ‘growth’ and ‘value’. Another is ‘quality’. Companies that score highly on quality attributes are generally those that are more stable and profitable and, as a result, are expected to deliver higher or more predictable investment returns.
How to spot quality
Quality companies tend to outperform in tougher economic conditions, given their more stable and predictable earnings.
Quality has many aspects. It can relate to business models. Companies with strong competitive advantages and market-leading positions – because their products or offerings are unique or because of barriers to entry such as knowhow, patents or strong brands – benefit from pricing power. This is demonstrated by consistently high profit margins and returns on invested capital, and strong cash generation. High returns on invested capital show that a company’s returns are above its cost of capital, enabling it to finance reinvestment to sustain its competitive edge and exploit growth opportunities. Sustainability of a business model is another key attribute of quality: if a company’s products have a low risk of obsolescence then its future revenues are more predictable and can be valued with more certainty today.
Quality in the form of predictability can also stem from a high degree of recurring or repeat revenues if a company’s product is business-critical or consumable. Examples here would include companies selling medicines or consumer staples which are consumed fairly consistently through the economic cycle, or licensing essential software through subscriptions. Low levels of financial leverage (debt) and a good management track record are other hallmarks of quality.
You could be forgiven for thinking that quality stocks, with their typically more resilient earnings, would have outperformed over the past year as the economic outlook has darkened. In fact, they’ve lagged. Why? It’s because many, if not most, quality stocks are also associated with the growth factor. As their name suggests, growth stocks are expected to deliver higher-than-average earnings growth. They’ve outperformed for many years, with high-growth companies’ valuations generally far outpacing those of slower growing stocks. But growth stocks’ price-earnings multiples are hurt more when interest rates rise, so they have sold off very sharply this year.
Some quality attributes are more prevalent in the growth cohort. Quality companies typically increase profits faster than the growth rate of the broader economy and ahead of their cost of capital (the average rate of return that shareholders and lenders demand for investing in the company). This creates a surplus that can be invested in growth opportunities at solid returns, reinforcing the company’s market position. The overlap between growth and quality companies means that many quality stocks have suffered in the growth sell-off.
A defensive quality sweet spot?
As we look ahead to 2023, we see a high risk of recession as central banks in the US, UK and Europe prioritise conquering inflation over supporting economic growth, coupled with energy and cost-of-living crises. This is a classic environment for quality companies to perform well in, as their earnings tend to hold up far better than lower-quality companies with less differentiation, more volatile demand for their products and services and weaker market positions.
Fortunately, there are pockets of quality companies that have defensive characteristics and resilient earnings in sectors such as consumer staples, defence and healthcare. These companies have the pricing power that enables them to pass on higher raw material and labour costs to their customers and to maintain their profit margins. We believe a quality-focused approach, with sensitivity to valuations, can help protect portfolios as the risks grow of a UK and wider global recession in the months ahead.
