How investing in quality securities stands you in good stead

AMID the market volatility over the past few months, the quality factor has continued to perform well. Over the past three months, the MSCI USA Quality Index managed to deliver returns of 7.06 per cent, whereas the MSCI USA Growth Index and the MSCI USA Index had returns of -2.69 per cent and 4.91 per cent, respectively. The quality factor has also managed to deliver strong performance over the long term, having outperformed the broader equity market and even the growth factor by a significant margin over the past 20 years. 

Given our view that the US economy is headed for a recession in 2023, we believe investors will be rewarded for taking on more exposure to the quality factor. But before we dive into the reasons why, let us define what quality investing is.

Quality investing can be defined as buying companies with durable long-term profitability, minimal solvency and financial risk, and high earnings quality. Quality can also be described as defensive, given that it is typically more resilient during times of market stress, especially during the later phase of the economic cycle such as today.

Outperformance in times of economic stress

There are a number of reasons why quality stocks tend to outperform growth stocks or even the broader market during times of economic stress, and it all boils down to how these stocks are selected. For instance, the MSCI USA Quality Index aims to identify high-quality US stocks based on three fundamental variables. These are high return on equity, low debt-to-equity, and low earnings variability. Companies in the index exhibit the strongest of these characteristics relative to their peers. Examples of such companies include Microsoft, Visa, and Apple.

Based on this screening methodology, it is obvious that a lot of emphasis has been placed on profitability and earnings quality, with two out of the three metrics taking this into account. This is important because share prices are ultimately driven by earnings growth in the long run. Companies with more sustainable earnings growth tend to see share prices appreciate in the long term.

Looking back in time, we can see very clearly that companies with high-quality earnings tend to experience much smaller declines relative to other companies. For instance, during the early days of the Covid-19 pandemic in 2020 and the current high inflationary, high interest rate environment, the trailing 12-month earnings growth of quality stocks declined by a much smaller magnitude than the broader market. Aside from this, high-quality companies are also less likely to see drastic negative revisions to their earnings per share (EPS) estimates, which can help support valuations.

In addition, these companies typically have robust balance sheets and are thus better positioned to withstand economic downturns. Many of them also possess competitive advantages and pricing power, allowing them to pass higher input costs to consumers without suffering a substantial loss in demand due to factors like demand inelasticity, brand power, and industry dominance, thus protecting their margins and earnings.

Visa, for instance, operates on a massive scale and is deeply entrenched within the global financial system. That has allowed it to grow its EPS by a mind-blowing compound annual growth rate of nearly 30 per cent over the past 10 years, in addition to its industry-leading profit margins.

Aside from their resilient share price performance, the defensive nature of high-quality companies is also evident in metrics such as their maximum drawdown. The MSCI USA Quality Index has a lower maximum drawdown than the broader market during times of economic stress, such as the dot-com bubble in 2000, the Global Financial Crisis in 2008, and the Covid-induced recession in early 2020. As such, the current uncertain macroeconomic environment has led us to favour a quality tilt.

Macro backdrop supportive of quality

Between the inverted yield curve, stubbornly high inflation, and a Federal Reserve that is aggressively raising rates, the US has been pushed to the brink of a recession. As of November 2022, the US Leading Economic Index (LEI) has fallen for nine consecutive months, with the latest reading coming in at -4 per cent year on year. The sustained and sharp downturn of the LEI suggests that economic conditions have deteriorated substantially, and we think that it is just a matter of time before the US enters a recession, if it isn’t already in one.

When the recession hits, the strong earnings growth delivered by most companies post-pandemic will likely be unsustainable. High inflation and steep borrowing costs will put downward pressure on revenues and margins, leading to lower, or worse, negative earnings growth. These are times when exposure to high-quality companies may be beneficial to investors’ portfolios.

Looking back at previous recession years when the MSCI USA Index registered negative earnings growth, we can see very clearly that companies with strong balance sheets, high-quality earnings, and stable cash flows were still able to deliver positive EPS growth for the most part, demonstrating their resilience when times got tough.

All in all, in the current macro environment where high inflation and aggressive monetary tightening are likely to lead to a recession, we believe that investors will benefit by incorporating some exposure to the quality factor in their portfolios. Those who are keen to do so may consider using ETFs, such as the JPMorgan US Quality Factor ETF, the Invesco S&P 500 Quality ETF, or the iShares MSCI Quality Factor ETF, just to name a few.

The writer is an assistant manager of the research & portfolio management team at FSMOne.com, the B2C division of iFAST Financial Pte Ltd. The latter is the Singapore subsidiary of SGX-listed iFAST Corporation