The next 12 months will be crucial for Quality

Glenn Freeman

Livewire Markets

The end of the dream run for Growth and a longer-term period of outperformance for Quality could be close, says Fairlight Asset Management portfolio manager Ian Carmichael.

As we established in the first part of this series, the Quality investment style – characterised by companies with solid balance sheets, high return on equity and good cash flow – have struggled over the last year. But perhaps not for much longer.

Why it's (almost) Quality stocks' time to shine
“I can't forecast the future, but I'd be very surprised if the environment wasn't very different 12 to 18 months from now,” Carmichael says.

We’ve all heard the “FOMO” portmanteau bandied about more frequently since the selloff and snap-back last year, which preceded the rapid rise in parts of Growth. But such catalysts tend to be fleeting, as indicated in our contributors’ responses in the following wire. I asked our three portfolio managers – listed below – what’s behind the poor showing from Quality in recent months and whether this has affected how they find opportunities within this broad investment style.

"The air can come out very quickly"

Ian Carmichael, portfolio manager, Fairlight Asset Management

To paraphrase JP Morgan, there's nothing worse than watching your neighbour get rich. When “blue-sky” stocks (and cryptocurrencies) are doing so well, there's no bid for quality companies now.

Of course, the air can come out of these things very quickly. I can't forecast the future, but I'd be very surprised if the environment wasn't very different 12 to 18 months from now. At that point, I think investors will again be rewarded for only owning companies that can reliably grow earnings more than the market.

If you ask people to name some high-quality companies they’ll point to things like Google, Facebook, Microsoft and CSL. The hard part is finding quality companies that are mispriced. We look for quality companies that are either misunderstood or that have had a setback.

We also look for companies that, today, don't meet that technical definition of quality, but where we can see a path there over the next three to five years. And there's certainly a quantitative aspect to it around profitability and stability but much of it comes down to qualitative insights such as pattern recognition in business models.

There are certain types of business models that we know are stable, enduring, and can be relied on to grow for multiple years. We look for marketplaces – businesses like property portal company REA Group (ASX: REA) or vehicle sales website (ASX: CAR) are local examples. At least a third of the Fairlight portfolio is allocated to marketplaces.

Once these businesses become dominant in their industry, they become very difficult to displace in delivering a lot of value to both sides of the marketplace. As an investor, you can be compensated for that with very strong and reliable profits.

Source: Gerd Altmann from Pixabay

Junk can’t win the long race

Jason Teh, founder and CIO, Vertium Asset Management

Quality companies tend to have higher ROEs for a reason: they have certain competitive advantages. Take CSL for example. Even though during COVID, the company couldn't collect as much from blood plasma collection centres, it’s a resilient business and survives whether it's a recession or not.

The recent underperformance of many quality stocks is the same reason why they outperform heading into a recession. The same market forces also drive Junk stocks to collapse heading into a recession but exhibit powerful rallies coming out of a recession. The demand for safety is less when investors are chasing junk stocks that offer a stronger cyclical earnings recovery.

Investors should also be aware that Quality can span both Growth and Value styles. Growth and Value stocks can be subdivided into high and low-quality stocks. 

In recent months, the outperformance of the Value style is the result of the value basket being dominated by low-quality companies. For example, resources, financials, and cyclicals have performed exceptionally well over the last year. The junk rally has driven the revival of the broad-based value factor. In fact, high-quality value has performed miserably.

Going forward, the junk outperformance will disappear as quality companies will outperform again over the long term. Junk rallies are often fleeting. For example, Aussie banks have experienced powerful rallies since last year but they can’t escape the fact that their ROEs have been declining over the last decade. On the other hand, companies like CSL or ResMed have relatively stable and high ROEs, which means their earnings power will continue to be strong in the future. Over the long term, lower-quality stocks will fall behind in their wake.

Quality stocks don’t exist in a vacuum

Kelli Meagher, portfolio manager, Sage Capital

Many Quality stocks also fall into the category of Growth. Growth stocks tend to do particularly well in times of falling bond yields which is what we have seen over the past few years if not decades. More recently as we have come out of the pandemic, we’ve seen a lot of the lower-quality Value stocks rally with expectations of an economic recovery and rising bond yields. Lower bond yields make future growth more valuable and Quality stocks more attractive, while the converse is also true.

If you have a long-term time horizon, a quality stock can provide good investment returns no matter what the flavour of the month is with regards to the market’s preference for value or growth or the direction of bond yields.

A company that is continuously growing and is earning a return above its cost of capital is creating shareholder value which will ultimately be reflected in a higher share price. In the long term, the growth in earnings from a high-quality company can swamp the cyclical valuation impacts from changing bond yields.

We run a style neutral portfolio to minimise systematic risk and avoid being over-exposed to changes in bond yields or big shifts in the market between value and growth.

A fundamental part of our bottom-up stock selection process is to assess the quality of a company on a variety of measures.

Key features we use to assess companies are:

  • industry structure and position within the industry,
  • sustainable competitive advantage,
  • how exposed the industry is to regulatory changes along with environmental and social risks,
  • the predictability of earnings.

We also look for companies with appropriate levels of debt, high returns on invested capital and good cash flow generation – in addition to plenty of opportunities to reinvest that cash flow to continue growing and creating value for shareholders. The quality of the management and board and long-term incentive structures are also important.

Of course, quality stocks are not always a good investment if you pay too much. Determining the quality of a company is helpful to determine how much to pay for a stock. We require a bigger discount to our valuation or “margin of safety” to buy a poor-quality stock versus a higher quality stock.

In summary

A combination of macro indicators such as bond yields and changing investor sentiment suggest another rotation is underway, which could see Quality stocks rise and fulfil at least some of the high expectations held by the above fund managers. Especially after such a wildly unpredictable 18 months, no one is betting the house on it, but the next year-and-a-half might see another changing of the guard as Growth drops back and Quality surges ahead.

Stay up to date with this series

Make sure you "FOLLOW" my profile to read the rest of this series. In part one, the three portfolio managers defined Quality and outlined characteristics they look for; and in part three they will dig into a few of their top stock tips from the Quality universe.

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Glenn Freeman
Content Editor
Livewire Markets

Glenn Freeman is a content editor at Livewire Markets. He has almost 20 years’ experience in financial services writing and editing. Glenn’s journalistic experience also spans energy and automotive, in both Australia and abroad – including the...

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