Quality Never Goes Out Of Fashion: Investing In High-Quality Companies
Economic growth will remain weak and vulnerable to shocks. Companies' profit margins are high and reflect a late positioning in the cycle. This is an ideal environment for quality stocks. A stock is deemed high quality when it meets three criteria: high profitability, a low gearing and low profit variability. These strengths warrant a high valuation. Companies investing heavily in research and development (R&D) are part of this defensive universe.
This theme allows investors to take a prudent approach to equity markets. This is reflected in price volatility, which is below the market average. It is therefore an ideal core holding for most investors who usually have a high loss aversion. This is especially true as nowadays the fixed-income universe plays a more minor role of regular income generator and portfolio stabiliser than in the past. This theme is global because growth in the world economy and profit trends are synchronised and both have reached high maturity levels. The investment horizon is by definition long term due to the theme’s defensive nature. Periods of relatively lacklustre performance are generally not too badly perceived by cautious investors because priority is given to earnings visibility in today's highly uncertain world.
A flagship style in 2019
Quality stocks delivered a much higher-than-average performance overall in 2019. Indeed, at the end of November, they were up 31% versus +24% for global equities.
A company is deemed 'quality' if it meets three criteria: high profitability, limited gearing and low profit variability. These stocks have benefited from persistent uncertainties linked to geopolitics, cycles and earnings growth.
Still a choice investment in 2020
The longevity of the current economic and stock market cycle is remarkable! It is very likely that the current decade will be the first one to escape a recession since records began. In any case, quality stocks tend to stand out in late stages of the cycle and outperform other market segments during recessions. They are core holdings in a portfolio.
During the first few months of 2020, it is very likely that quality stocks will not perform as well as in 2019, for two reasons: a return of confidence in the economic climate and a high valuation. Admittedly, when leading indicators begin a new uptrend, the pro-cyclical equity market segments are the main winners. However, we expect the cyclical momentum to remain soft. This will maintain investor interest in investments with above-average visibility at a high level. For this reason, valuations will remain stretched.
In addition, stock market volatility has remained low of late. In the course of 2020, it is expected to begin an upswing. Historically, this factor benefits quality stocks.
The majority of investors have a conservative investment profile. This is reflected in a smaller focus on the relative performance of quality stocks and a greater focus on volatility and downside risks. If we combine these characteristics with our low earnings growth forecasts for 2020, quality stocks are a prime investment. A potential widening of credit spreads would increase the attractiveness of quality stocks.
A segment not to be overlooked: companies with high R&D costs
Beyond the official definition of a quality stock, companies investing heavily in R&D are also a quality investment. The logic is the following: investing in knowledge leads to an above-average return on equity. Furthermore, investing in knowledge creates value added and barriers to entry. As a result, the capacity to raise sale prices improves and the generation of significant cash flows increases. At the end of the chain, dividends are not only better protected but are also easier to increase.
This type of company is found mainly in the health care and technology sectors.
As for any investment in equity markets, a bear market generates capital losses. And these losses could be substantial. Compared with other investment styles, however, these losses are likely to be smaller. Quality stocks have become expensive following a very good run in 2019. Accordingly, they have less upward potential. A marked recovery in leading indicators would reduce investor appetite for defensive investments, leading to an underperformance. A clearly bullish market trend would be detrimental in relative terms due to below-average growth.