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By Evgeny Dunaevsky
Companies with proven profitability, resilient business models and other quality attributes appear well-suited for this uncertain environment.
Despite November’s surprising equity rally, we believe elevated interest rates and uncertainty about the economy’s near-term trajectory will continue to reward the quality factor. At the same time, we do not believe all quality-focused portfolios are equally predictive of future performance – mainly because the exact metrics used to recognize high-quality companies are not universally agreed upon.
Quality has always mattered. Between 1990 and 2020, S&P Global found that the top quintile of quality stocks returned 1.16% per month, while the bottom quartile mustered just .82% per month1; more recently, the MSCI World Quality Index outpaced the MSCI World Index by an annual 2.79% between December 18, 2012 (the quality index’s inception) and October 31, 2023.
Yet, the quality factor especially tends to shine when the economy sputters and investors flock to companies with proven profitability and resilient operational models. Indeed, during the 2001 dotcom crash, the 2008 Global Financial Crisis and the Covid-19 pandemic, quality indices suffered less drawdown than their broader-market counterparts2.
Broadly speaking, quality metrics seek to measure a company’s profitability and capital discipline. More specifically, we believe proper quality assessment should consider a wide range of metrics – our quantitative investing models track 16 quality-based financial variables in the industrials sector – including their absolute levels and trends over time. Customizing the analysis by sector is important, too: For example, we view a bank’s return on equity as arguably a better gauge of its quality than its return on assets. We also believe non-traditional measures – such as corporate governance scores – can add crucial insight as well.
Minding those metrics could serve investors well if current risks mount. In November 2023, the U.S. Federal Reserve held its key lending rate steady at a 22-year-high, while the U.S. unemployment rate, now at 3.9%, has ticked up 0.5% from a cycle low set 10 months prior, possibly indicating the start of a recession.3
We believe quality companies are well suited for this uncertain environment, thanks to their moderate leverage (and lower exposure to higher rates) and higher profitability (a welcome cushion in a potential downturn). In short, we think quality matters – especially now.
Sources & Notes: (1) S&P Dow Jones Indices: Factor Indices: A Simple Compendium December 2021; (2) NB Research; (3) According to “The Sahm govern” which identifies signals related to the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to its low during the previous 12 months.
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