Why quality stocks offer higher return
For many years, investors thought of “Growth” investing as the natural complement to Value based investment strategies. However, disappointment with the diversification properties of Growth and the failure to identify a sustainable return premium attached to Growth stocks has more recently revived interest in the concept of Quality as both a stand-alone strategy and one that is highly diversifying with Value.
The Schroders QEP Global Equity Team has been promoting the merits of investing in Quality for almost two decades and has offered a stand-alone Global Quality strategy since 2007. The strategy invests in financially strong companies that have a demonstrated record of generating superior and stable profitability. We believe that Quality is a more systematic and predictable investment approach than typical growth investing as it explicitly avoids the disappointment that is often associated with more glamorous stocks.
More specifically, our analysis suggests that Quality companies generate a return premium in excess of the market over time with lower risk whilst we also observe that this return is accentuated when risk aversion is high or rising. Historically, many of these periods have often been associated with Value strategies underperforming, meaning that Quality also appears to offer significant strategic diversification to Value approaches.
The complementary role of Value and Quality does not appear to be spurious. We observe that higher quality companies have very different characteristics to Value stocks which are often less profitable, more cyclical and exhibit weaker balance sheets. Philosophically, it is also possible to argue that high quality companies are complementary to Value in the sense investors fail to incorporate the persistence of the positive attributes of quality companies into the future, particularly their profitability, whereas the opposite is often true for stocks with weaker fundamentals (which creates the value opportunity). The complementary nature of Value and Quality enables investors to construct a more balanced equity portfolio which is more likely to perform across a broad range of market environments.
In this paper we highlight how higher Quality companies typically offer higher returns to investors which we believe is at least in part linked to the observation that they are more likely to experience favourable corporate events. We also show that Quality companies are able to sustain elevated profitability levels relative to the wider market for protracted periods which does not appear to be fully valued, thereby creating a justification for the Quality premium. In contrast, investors actually tend to overpay for “Growth”, either as part of a lottery effect or because they get sucked into glamour trades which leads to the outperformance of the “slow and steady” companies where strong fundamentals are not fully priced.
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