Why quality pays in late-cycle periods

Why quality pays in late-cycle periods

BY David Bassanese | 27 February 2019
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Quality pays in late cycle

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History suggests that so-called “quality” companies, i.e. those with a high return on equity (or “ROE”), tend to be able to produce market-beating shareholder returns over time.  As this note details, moreover, quality companies have tended to especially outperform in “late-cycle” market periods, as investors have tended to gravitate toward companies with strong balance sheets and durable profitability.

Factor investing and the case for quality

So-called “factor investing” is an increasingly popular rules-based strategy that aims to select companies likely to outperform the broader market over time.  Factors are identified corporate characteristics that have tended to be associated with share market outperformance – either over time and/or at least at different stages of the market cycle.

Popular factors include:

  • Momentum – companies displaying relatively strong share price performance over recent times.
  • Value – companies trading at relatively low price-to-earnings or price-to-book value ratios compared to the broader market.
  • Small cap – companies with relatively low market capitalisation compared to the broader market.
  • Low volatility – companies that tend to exhibit relatively low share price volatility over time.
  • Quality – companies with relatively high returns on equity and only moderate levels of leverage.

As seen in the chart below, long-run analysis of the performance of “Quality” companies in the U.S. indicates that this factor has not only outperformed the broader U.S. market over time, but periods of outperformance have been most apparent during late-cycle or bear market periods.

MSCI U.S. Quality Index vs US S&P 500 Index 

Source: Bloomberg. Past performance is not an indicator of future performance. You cannot invest directly in an index.

The BetaShares Global Quality Leaders ETF (ASX Code: QLTY)

The Quality factor also tends to perform well at the global level. As seen in the chart below, the MSCI Ex-Australia “Quality” Index has tended to outperform the broader MSCI World Index over the past decade or so, with this outperformance most apparent during periods of market weakness (as indicated by the shaded areas).

Recognising the positive attributes of the Quality factor, BetaShares has recently introduced a Quality factor product over global shares in our QLTY ETF – BetaShares Global Quality Leader ETF.  QLTY aims to track the iSTOXX MUTB Global Ex-Australia Quality Leaders Index. As seen below, this Index has also performed well compared to the MSCI Ex-Australia Quality Index over the longer term.

MSCI World Reurn Index ($A)

QLTY’s Index v MSCI World (AUD): December 2002 – December 2018

Source: Bloomberg. Does not take into account ETF fees and costs. Past performance is not an indicator of future performance of index or ETF. You cannot invest directly in an index.

The Index that QLTY aims to track selects the top 150 global companies that meet certain profitability and balance sheet quality metrics. Keeping the number of stocks to 150 means that the Index focuses on stocks that have high average scores in terms of ’Quality’ characteristics.

The Index is also unique in that applies a cash flow generation screen – on the view that companies which are best able to convert good returns on equity into relatively good cash flows should be relatively well positioned to sustain good profitability over time.

That’s important because, as seen in the chart below, history suggests that among companies with a high current ROE, those that are able to sustain a high ROE over future years tend to significantly outperform those that can’t.  In picking quality companies, current ROE levels is a good first step – but it’s the sustainability of ROE that truly counts.

For more information on QLTY, you can view the fund page, request an info pack or download further information.

 

3 Comments

  1. BRIAN O'KANE  |  February 27, 2019

    A very good synopsis

  2. Steven Goodman  |  February 28, 2019

    Why doesn’t QLTY track the index more closely?

    1. Gavin Montgomery  |  March 4, 2019

      Hi Steven,

      Thank you for the enquiry. QLTY actually aim’s to track the iSTOXX MUTB Global Ex-Australia Quality Leaders Index, which it does so very closely.
      Historically this index has outperformed the MSCI World Ex Aus Quality index. The deviation of these indices may be attributed to the structural differences, such as a more concentrated holding of underlying assets in the iSTOXX index with 150 assets versus the MSCI’s 300 assets.

      If you did have any further enquiries, you are welcome to either email us at info@betashares.com.au or call us on 1300 487 577.

      Thanks,
      BetaShares Client Services

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