Investment managers tend to have a guiding philosophy, which governs the type of companies they pick. They may like solid, dependable companies that can compound invested capital over time. Or they may like unloved companies, where there is the opportunity for a turnaround. Each approach may have periods in and out of favour.
The market values different characteristics at different points in the economic cycle. For example, when the market is nervous about the outlook, investors may gravitate towards high quality companies that may be more resilient in a weak economic environment. When investors are more optimistic, they may seek out high growth companies. Judging when these ‘factors’ may come in and out of favour can be useful for investors. At the moment, for example, the ‘quality’ factor has been significantly out of favour and may be due for a comeback.
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‘Factors’ are an inexact science, but broadly, value stocks tend to be those areas unloved by the market where valuations are low. Growth stocks are those with a superior level of earnings growth to the wider market. Momentum stocks are those where prices are rising fast. Finally, quality stocks are those with certain characteristics – such as strong cash flow, resilient earnings, or an established brand. A stock is rarely purely a quality, value or growth stock, and companies may fall into any individual category at various stages in the market lifecycle.
Over the past 12 months, investors have favoured either value or growth, with quality companies notably lagging. The MSCI World Quality index is up just 7% over the past 12 months, compared to a rise of 16.8% in the MSCI World index*.
The sector make-up of the quality index has contributed to this weakness. Around 30% is in information technology and particularly in familiar names such as Nvidia, Microsoft, Meta and Apple*. While Nvidia has done well, it has been a tougher period for Apple and a number of the other technology giants. Equally, consumer giants such as Costco, also an important index component, have struggled amid fears on the health of the US retail economy.
Factors tend to go in cycles and it may be that investors start to favour the type of characteristics that quality companies offer, particularly in a less certain economic and political environment. The tariff situation in the US has created concern over the strength of economic growth, and a possible revival in inflation. Equally, interest rates are coming down more slowly than expected. In theory, this should favour companies with strong pricing power, low debt and resilient business models – exactly the type of characteristics a quality focused manager would prioritise.
Fund managers who take this ‘quality’ approach include Montanaro, Marlborough, many of the funds at Aberdeen, and also individual funds such as the BlackRock Global Unconstrained Equity fund or the AXA Framlington UK Mid-Cap fund. Montanaro, for example, believes it is worth paying more for “a well-managed, financially sound business that operates in a growth industry and enjoys a sustainable competitive advantage. Businesses with such quality characteristics are able to ‘beat the fade’ and maintain a high return on capital over the long term.”
For them, this includes “simple business models, profitable companies, niche businesses in growth markets, market leaders, high operating margins and high returns on capital and good management we can trust”. The team also pay attention to a country’s sustainability risks – is it managing its environmental impact? Treating its staff properly? Is it a good corporate citizen?
Within the UK Income fund, this includes companies such as Games Workshop – the owner of the Warhammer 40,000 franchise, or Hill & Smith, a group of specialised engineering businesses linked to infrastructure construction in the US and UK**.
The Aberdeen smaller companies team, which manages the Aberdeen Global Smaller Companies fund, also incorporates quality considerations into its process, alongside growth and momentum factors. It believes that quality is particularly important for smaller companies, helping to manage risk and highlight companies with lower debt and a strong pathway of sustainable growth.
Manager Abby Glennie says: “We find that businesses with these characteristics have generally been able to navigate a tougher economic climate successfully. They may even profit from them in the longer term as their competitors struggle. However, in the short-term, investors tend to treat these high-quality companies in the same way as their peers, which creates opportunities for long-term investors to buy at lower valuations. This, we believe, is the situation today.” The portfolio includes companies such as Encompass Health, the US’s largest provider of inpatient rehabilitative services***.
Marlborough is another group that prioritises quality characteristics across its funds, including the IFSL Marlborough Special Situations fund. It also has a smaller company skew, and prioritising quality characteristics helps it avoid some of the pitfalls of earlier-stage companies. It has an eclectic portfolio that includes groups such as Volex, an industrial cable supplier, information management software group Idox and defence company Chemring****.
The quality factor has been surprisingly weak at a time when there has been growing uncertainty about the world’s economic prospects. Investors may start to value these characteristics more highly as the world adjusts to higher tariffs and a more sluggish outlook. Buying higher quality companies after a period of weakness has generally been a good long-term strategy.
