Could it be time for a resurgence in quality?
Valuation spreads suggest quality style tailwinds may be near for non-US equities.
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The power of endurance
Quality investing is a style generally characterized by companies that are financially stable with low levels of debt and that generate strong, consistent levels of profitability. These companies typically possess a competitive moat and earn a healthy spread above their cost of capital. But perhaps most importantly, they enjoy strong reinvestment opportunities and that provides them with the power to compound returns across market cycles. These businesses often command higher valuations, but quality is also widely considered one of the best-performing and most consistent investment style factors over the long term.
Investment styles generally mean revert over time but can demonstrate powerful leadership over discrete shorter periods. During periods of low interest rates or in the middle to late stages of an economic cycle, growth stocks have often outperformed. Value stocks have often led markets during periods of economic recoveries or during periods of rising inflation and interest rates. Quality stocks have often outperformed amid periods of higher volatility, economic uncertainty or in recessionary periods, but also tend to deliver the most consistent performance. In fact, over the long term (15-20 years) through various cycles, quality has been a modestly outperforming style factor in international (non-US) equities (see Figure 1).
Figure 1: Quality has outperformed over the long term but more recently has significantly lagged value
Annualized excess returns by style (MSCI ACWI ex USA)
Past performance is not a guide to future performance and may not be repeated. Source: Schroders as of March 31, 2026. Performance figures shown are gross of fees in USD. Bars are showing the excess returns for the style indices vs the MSCI ACWI ex USA Index. “Quality” is represented by the relative performance of the MSCI ACWI ex USA Quality Index (NR). “Growth” is represented by the relative performance of the MSCI ACWI ex USA Growth Index (NR). “Value” is represented by the relative performance of the MSCI ACWI ex USA Value Index (NR).
However, in recent years we have seen a significant rotation toward value within international equity (non-US) markets, with the performance gap between quality and value stocks reaching approximately 10% per year over the past three years. Amid geopolitical volatility, AI disruption and very short-term oriented, narrative-driven markets, quality has experienced one of its worst drawdowns in decades. (See Figure 2.)
Figure 2: Quality has underperformed the market by 19% in EAFE over the past three years, one of its worst drawdowns
Rolling 36-month cumulative performance in USD terms: MSCI EAFE Quality - MSCI EAFE
Past performance is not a guide to future performance and may not be repeated. EAFE = Europe, Australasia, and the Far East, a stock market index designed to represent global developed markets excluding North America. Chart shows performance MSCI EAFE Quality relative to MSCI EAFE. Returns have not been annualized. Data to March 2026. Source: LSEG DataStream, MSCI.
Valuation spreads point toward improving performance in quality
Valuation spreads measure the gap between the cheapest and the most expensive stocks and can provide a helpful barometer for the relative attractiveness across quality, growth and value style performance.
A wider spread for the top quintile suggests that the most expensive stocks are overvalued relative to the cheapest stocks, whereas a narrow spread suggests investors are willing to accept lower premiums for taking on risk and can often signal complacency risk in markets. While tight spreads reflect a positive environment, they can also signal market frothiness or overvaluation, as seen in historical periods where they preceded increased volatility.
The top quintile is most frequently a proxy for growth and quality businesses that typically command a premium valuation. Perhaps not surprisingly, it is during recessionary periods when investors have most frequently been willing to pay more for visibility of earnings, as dispersion is the widest. In Figure 3, zero represents the long-term average, and when dispersion is the lowest, it shows that investors are not distinguishing much between higher-returning businesses and the rest. These periods of low differentiation have generally occurred when value stocks led the market.
Narrow valuation spreads between growth and value stocks suggest that the “cheap” stocks are not significantly discounted compared to “expensive” ones, and that reduces the expected premium for value-based strategies. Recency bias in behavioral finance highlights the cognitive tendency of investors to overemphasize recent events while ignoring long-term historical and forward-looking, fundamental data.
While the performance momentum in value stocks has been exceptionally strong over the past few years, the extreme narrowness currently in valuation spreads would suggest that now is actually a good time to consider adding to quality.
Figure 3: Narrow disparities tend to be highly supportive for the strong performance of quality and durable growth
Developed markets (ex US) valuation spreads: The top quintile compared to the market average, 1987 through March 2026
Past performance provides no guarantee of future results and may not be repeated. Source: Empirical Research Partners Analysis, Schroders, as of March 31, 2026. The spread is based on the price-to-book data for the regional index from January 1987 through March 2026. Valuation spreads assess the top quintile versus the regional average measured in standard deviations.
Why now might be the worst time to give up on quality…
Historically, when valuation dispersion has been extremely low (as it is now), quality has most often been the best-performing style factor in the ensuing periods, both over one- and three-year annualized periods. In the past 40 years, valuation dispersion across international developed markets has rarely been as low as -1.0 or more standard deviations and has most often found a floor closer to -0.5. With dispersion reaching -0.85 in January 2026 and currently sitting at -0.79 at the end of the first quarter of 2026, it begs the question: Where do we go from here?
As illustrated in Figures 4 and 5, these low points have often been the best times to allocate toward quality while, conversely, the peaks when dispersion has been the widest have often been a good time to allocate more toward value. In the last four troughs, we have seen quality outperform value by an average spread of 7.7% in the ensuing one-year period and by a spread of 5.5% annualized over the ensuing three-year period. Evidence would suggest that now is an opportune time to lean into quality, but all too often we see investors fall into the behavioral trap of chasing performance and selling quality at the wrong time in the cycle.
Figure 4: Style performance for 1-year period following dispersion low point
Figure 5: Style performance for 3-year period following dispersion low point
Past performance provides no guarantee of future returns and may not be repeated. Source: eVestment, MSCI, Empirical Research, Schroders. Data evaluated over a near 40-year period from January 1, 1987 to March 31, 2026. Relative style performance is illustrated by the annualized excess return of the MSCI EAFE Growth Index (ND), MSCI EAFE Value Index (ND) and MSCI EAFE Quality Index (ND) versus the MSCI EAFE Index (ND), following the period when dispersion hit a low. Please note that data for the quality index is not available prior to July 1994. Excess returns are shown for both the one-year and three-year annualized periods in US dollars.
Durable earnings are most valued amid rising uncertainty and volatility
Price momentum has been an exceptionally strong factor in the past couple of years while earnings momentum has been more rewarded in some parts of the market than others. In the long term, it is always earnings that drive equity markets, but the market has recently experienced particularly acute policy distortions and a macro backdrop that has continued to favor cyclical beta, while stability and defensiveness have been discounted.
There are a number of factors currently looming on the horizon that could change this narrative, including a cyclical slowdown, earnings downgrades or credit stress, and all of them could contribute to more volatility. Given the current market backdrop, there is a credible case for any of those conditions to materialize. Also, valuations and valuation spreads are at extended levels, and that alone could be enough to initiate a change in market performance trends.
The risk of a correction remains pronounced, which also may send investors to seek shelter in some of the more unloved, cash-generative and well-funded defensive companies. While the cyclical value leadership may persist for some time, 40 years of international equity market cycles and valuation spreads would suggest we are very near an inflection back toward quality leadership.
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