While investment style and market timing will never explain all of an investment’s returns – collectively, they can account for a very meaningful proportion of it. We would argue that there have been several periods in recent history when investors have been presented with an opportunity to build exposure to the highest quality companies in the world at a time when their valuations, relative to other parts of the market, have become very attractive. We feel that now – January 30th 2017 – is one of those times.
Global Quality Performance over various time periods
While all active Quality investors – including ourselves – would argue that our approach to Quality investing is unique, for the sake of the argument we are putting forward, we will make some observations about the MSCI World Quality Index as a common reference point for Quality investing. We would note that the Quality index itself was launched in December 2012, and any data points pre-dating that time have been back-tested by MSCI.
The table below examines the recent performance of the MSCI World Quality Index vs MSCI World Index. What has become abundantly clear in the last 6 months, is that Quality as an investment style has been out of fashion. The U.S. election result last year triggered a strong rally in a wide range of stocks and sectors that are not typically synonymous with Quality investing. The result being that Quality stocks lagged quite materially over a relatively short time period and the relative valuations between the Quality index and MSCI World Index contracted to the point where the Quality P/E trades at a historically modest premium of 0.85 P/E points to the broader market. (i.e. MSCI Quality P/E Fwd 17.12 vs MSCI World P/E Fwd 16.27)
The table below looks at the performance of the two indices over calendar years since 2003. We would note the following :
- The Quality Index has outperformed over time
- Quality has outperformed in 7 / 14 calendar years
- Quality has delivered very strong outperformance during periods of overall market weakness (i.e. 2011 and 2008)
What can we conclude from this data?
Given that global equity markets are currently trading at their highs, we believe there are some strong arguments for investors to make a tactical shift to Quality as a style:
- Mean Reversion: we would argue that the recent strong rally in ‘Junk’ stocks are understandable but unsustainable. Short term investors were caught wrong footed by the Trump election victory and have aggressively repositioned their portfolios to reflect common perceptions about what a Trump administration means for equity markets. As we look closer at what lies ahead for 2017, we suspect that investors may well adopt a more cautious tone as European politics and the daily machinations of the Trump administration take centre stage. In this type of environment, we would suspect Quality to perform very well in a relative sense.
- Toppy Valuations: at the risk of stating the obvious, global equity valuations are near their highs. The MSCI World Index P/E of 16.27 is trading at a ~ 19% premium to it’s 10 year average. Without going into whether the premium is justified or not, we would put forward the view that valuation risk is higher than it has been for some time and is particularly high in lower quality ‘Junk’ stocks. If we start to see some disappointment from the expensive cyclicals like Caterpillar for example (P/E of 31.3x), then we could see some rotation into Quality names with less fundamental and relative valuation risk.
- Downside Protection: given that global equities haven’t delivered an annual negative return of more than 1% since 2011, we think it’s prudent for all investors – including ourselves – to give very careful thought to how their portfolios will perform in a period where stocks have a decent correction. From a pure style perspective, for the reasons already explained, we would expect that a Quality portfolio will preserve capital better than the market itself and certainly better than the expensive ‘Junk’ stocks – until recently known as ‘Value’ stocks.
Aren’t Quality companies still really expensive?
This is one of the most common questions we get in meetings with clients and prospects.
We would make the following points:
- The P/E of the MSCI Quality Index is at a fairly modest premium to the broader market (i.e. MSCI Quality P/E Fwd 17.12 vs MSCI World P/E Fwd 16.27)
- Given that the companies in the Quality Index obviously have better fundamentals than the index as a whole, they arguably deserve to trade at a higher premium to the market as a whole. By way of illustration, the average ROE of the top 10 constituents of the Quality index is 22.3%, which compares with 9.5% for the MSCI World Index as a whole*.
- There are arguably pockets of the broader Quality universe, such as Consumer Staples, which still trade at a P/E premium to the broader market, but the premium has dissipated – specifically the index premium has shrunk from 37.7% in Feb 2016 to a 17.7% premium as at the end of 2016 which is marginally below the 10 year average.
Overall, we believe that global equity investors should consider making a tactical shift towards Quality for the reasons laid out.
While overall market valuations are historically expensive, one way that investors can improve their portfolio positioning for a) short-term down side protection, and b) long term capital appreciation, is by allocating additional capital to a Quality strategy.
*For more details about the MSCI Quality index see https://www.msci.com/quality-factor