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Tough times call for quality stocks, but finding them can be harder than it looks

Tough times call for quality stocks, but finding them can be harder than it looks

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6 minute read

The sell-off in equity markets has many investors naturally looking for a defensive strategy. One such option is to shift into quality companies that are likely to prosper despite the downward turn in the market cycle ride out the turmoil, while others suggest a rotation to value. 

Investing in quality might sound obvious, but behind the simple description lies a wide variety of opinion and evidence on how to determine which company really fits the description. 

A research paper written by Jason Hsu, Vitali Kalesnik and Engin Kose in 2018 entitled What is Quality? found that for a true long-term return, premium evidence suggests the best returns are from companies which offer a combination of profitability with solid investment characteristics.

The research also suggested companies displaying characteristics of profitability, accounting quality, pay out/dilution and investment-delivered superior performances.

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But surprisingly, the authors found delivering earnings stability, capital structure and growth in profitability showed no robust evidence of producing a premium return on the market.

Quality investing on a growth path

Quality as an investing concept can be traced back to Benjamin Graham and his 1949 book The Intelligent Investor. It became more popular around the early 2000s following the bursting of the dotcom bubble and other spectacular failures like US energy company, Enron and telephone group, WorldCom.

It is also associated with Warren Buffet and his Berkshire Hathaway Group, which invests in a diversified group of major brands based on a qualitative investment approach. Buffet has said investors should only buy stocks in companies that exhibit solid fundamentals, strong earnings power and the potential for continued growth.

An academic study by Andrea Frazzini, David Kabiller and Lasse Heje Pedersen found Buffett’s focus on buying high-quality stocks largely explains the performance of the listed stock portfolio held by Berkshire Hathaway, which from 1965 through the end of 2021, generated a compound annual return of 20.1 per cent against 10.5 per cent for the S&P 500. 

Defining a quality stock

Today and here, quality investing is often defined as investing in stocks which have higher return on equity (ROE), sustainable earnings and low financial leverage. 

More specifically, quality stocks can be assessed as having three key characteristics:

  • Profitability – Particularly return on equity, cash flow generation and the margins of the business — which measure the ability of the company to generate profits from its assets.

  • Stability – This requires an analysis of the likely growth of dividends, the stability of cash flows, earnings, and sales over time. There are other factors as well such as capital expenditure, the ratio of investment to assets and recent asset growth, to name a few.

  • Financial strength – Companies with modest leverage and an ample ability to service that debt with some cash in the bank are better placed to manage slowdowns in the macroeconomic environment. 

There is no great consensus as to which of these measures is the most appropriate or provides the best results; however, what the research does agree on is that quality stocks have historically outperformed the market, with relatively low volatility, over long time periods. 

A portfolio of quality stocks produces better risk-adjusted returns over time than the market average. For example, in recent years MSCI, FTSE Russell, and S&P, among others, have created quality smart beta indices and have typically included quality as part of their multi-factor offerings.

But, according to the research by Hsu, Kalesnik and Kose cited above, the lack of a consistent definition of quality, combined with the evidence that the components used to determine quality vary from having a strong impact to no statistically significant impact — which means that how an index is constructed will have a major impact on how it performs as a quality factor. In particular, they found earnings stability, capital structure and growth in profitability had minimal, if any, impact on generating superior returns from a quality investment strategy.

How to invest 

On the ASX, there are many firms that might meet the definition of quality, and some that are regularly mentioned by analysts are Macquarie Group (ASX: MQG), CSL (ASX: CSL), Woolworths Group (ASX: WOW) and Wesfarmers (ASX: WES).

Obviously, there is a lot of work involved in assessing the company accounts of listed firms to create a portfolio of top-quality stocks. However, as is often the case, there is the potential of using an ETF.

One such quality-focused ETF for shares listed on the ASX is the BetaShares Australian Quality ETF (ASX: AQLT). Or for a more globally focused portfolio, there is the BetaShares Global Quality Leaders ETF (ASX: QLTY).

VanEck also offers the MSCI World ex-Australia Quality ETF (ASX: QUAL); along with the VanEck MSCI International Quality (Hedged) ETF (ASX:QHAL); the VanEck MSCI International Small Companies Quality ETF (ASX:QSML); and the Australian VanEck Small Companies Masters ETF (ASX:MVS). There is also the SPDR MSCI World Quality Mix ETF (ASX: QMIX).

AQLT offers exposure to companies with a high ‘composite quality score,’ which is based on key financial metrics such as return-on-equity, debt-to-equity, and relative earnings stability over the last five years.

VanEck’s QUAL ETF gives investors exposure to a diversified portfolio of quality international companies listed on exchanges in developed markets around the world outside of Australia and has returned 14.37 per cent p.a. since inception to 27 July 2022. Investors have noticed with AUSIEX trading data showing that the VanEck’s QUAL ETF was the second most actively traded ETF at the end of July 2022.

Detailed analysis is key

As an investment strategy in a period of uncertainty, building a quality portfolio seems an obvious choice but it is important to understand that not all products labelled ‘quality’ will be alike.

The large variety of methods for constructing a quality index and the different interpretations of the term mean that an investor needs to understand the detail of the product approach before making an investment decision.

Brett Grant, head of product and trading, AUSIEX

Tough times call for quality stocks, but finding them can be harder than it looks

The sell-off in equity markets has many investors naturally looking for a defensive strategy. One such option is to shift into quality companies that are likely to prosper despite the downward turn in the market cycle ride out the turmoil, while others suggest a rotation to value. 

Tough times call for quality stocks, but finding them can be harder than it looks
Tough times call for quality stocks, but finding them can be harder than it looks
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Neil Griffiths

Neil Griffiths

Neil is the Deputy Editor of the wealth titles, including ifa and InvestorDaily. 

Neil is also the host of the ifa show podcast.

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