By Olivier Lebleu
While the equity markets have produced strong returns in recent years – for example, the S&P 500 is up over 150% since its March 2009 low – economic uncertainty has persisted throughout this period, driven by broad concerns about the future tax, spending, monetary and regulatory policies of major nations around the world.
In this period of market instability, many commentators have discussed the attractiveness of investing in “quality” companies, which are perceived to have greater resilience to economic volatility than their lower quality peers. Indeed, while turbulence or decline in the equity markets often brings with it observations of a “flight to quality” among investors, those who favour quality investing emphasise its success as an enduring strategy over full market cycles.
Quality investing is generally recognised as an outgrowth of Benjamin Graham’s core investment principles. Graham embedded the concept of quality in his value investment philosophy – the first five of his seven key criteria for successful equity investing are effectively quality- focused metrics. Graham’s conception of value investing was not simply to buy cheap stocks, but to buy undervalued ones – high quality firms that traded at a discount. His quality factors sought to discern the intrinsic financial position of a company – its historical performance and prospects for future growth.
Though the concept of quality investing is widespread, conclusive long-term performance evidence specific to this investment style can be harder to find. Warren Buffett is among Benjamin Graham’s most notable adherents, and his implementation of Graham’s value approach has led him to earn extraordinary investment returns. For the 25 years ending 2012 – a period encompassing various market crashes and corrections – Buffett’s total returns are five times those of the S&P 500.
The short-term performance of quality, however, bears some further analysis. For the last 10 years we can enhance our examination of quality returns through the S&P’s High and Low Quality indices, which systematically classify companies in the S&P index according to the kind of quality metrics first identified by Graham. Data from the S&P can roughly be broken down into two distinct periods; the years from June 2003 to June 2008, which broadly coincide with dates that encapsulate the market recovery post the TMT crash to the onset of the financial crisis, post the Bear Stearns collapse and the years from June 2008 to the current period ending June 2013.
There are clear differences in this 10-year cycle. Lower quality stocks substantially outperformed high quality stocks in the five years leading up to the financial crisis. While still strong, their relative performance has declined considerably since 2008. We also see that the performance of higher quality stocks has markedly improved since 2008, although it continues to lag lower quality stocks over the entire period.
So given the evidence for long-term performance of quality, and the recent recovery in quality returns, what may investors conclude about the period ahead when considering a quality approach? In my view, the most plausible explanation for lower quality company outperformance over the past 10 years is linked to the unusually loose monetary policies that dominated in the beginning of the last decade post the TMT crash, as well as in the immediate aftermath of the 2008 crisis. In both instances, which coincide with the period of strongest outperformance for low quality stocks, loose monetary conditions allowed companies across the quality spectrum to refinance despite macroeconomic stress – in effect setting the stage for a junk rally led by lower quality stocks once investor fears of systemic meltdown were assuaged.
Quality investing offers both safety and opportunity. While research has demonstrated that a quality portfolio can produce meaningful returns over the long term, there are also advantageous entry points as markets fluctuate. Is now the time? Investors will decide for themselves, but quality is still “good value”.
Olivier Lebleu is head of international business at Old Mutual Asset Management
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