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Market cap-weighted share indices can tend to overweight overvalued stocks and underweight undervalued stocks. Investing based on quality, on the other hand, does not consider a stock’s market capitalisation – rather it applies certain quality factors.
This approach aims to produce superior performance to market cap-weighted indices, and arguably best demonstrates its merits when markets fall.
What do we mean by ‘quality’?
Quality as an investment style follows the thesis that companies with strong balance sheets that are highly profitable, operationally efficient and well-governed offer better risk-adjusted returns relative to the market over the long term.
This approach holds that quality companies with durable business models and sustainable competitive advantages are better able to weather differing economic conditions. When markets pull back or are volatile, investors tend to turn to companies with strong current profitability rather than companies that are promising/forecasting future revenue growth.
The BetaShares Global Quality Leaders ETF (ASX Code: QLTY) has been designed to provide investors with exposure to a diversified portfolio of global companies (ex-Australia) that demonstrate ‘quality’ characteristics.
To identify quality companies, we believe these metrics need to be considered:
- Return on equity
- Business stability
- Financial health
Companies ranking strongly on these factors historically have outperformed during the slowdown and contraction phases of the economic cycle, demonstrating lower volatility and smaller drawdowns than the broader market during market declines and periods of heightened volatility. During the GFC, for example (Oct 07 – March 09), the index QLTY aims to track outperformed MSCI World by ~20%.
The table below illustrates the performance of QLTY’s index relative to the MSCI World during recent market shocks:
Source: Bloomberg. QLTY’s Index is the iSTOXX MUTB Global Ex-Australia Quality Leaders Index. You can’t invest directly in an index. Past performance is not indicative of future performance.
Of course it’s very difficult to accurately predict when the current bull market will end. As such, QLTY offers investors a way to maintain an exposure to equities and participate in any further rally, whilst at the same time providing potential for relatively reduced downside if a downturn was to occur.
Sustainability of ROE
One key metric worth highlighting is the sustainability of ROEs. We believe that certain metrics can help identify companies with sustainably high ROEs. QLTY’s index considers the following ROE related factors.
Companies with higher than average ROEs at any given time are a natural starting point.
Additionally, companies with low leverage (i.e. debt relative to equity) are less likely to be affected by changing market conditions and more likely to maintain their ROE over time. The same can be said for companies with high profitability (i.e. strong cash-flow generation ability).
Finally, companies with a consistent track record of strong earnings (or low variability in earnings) are more likely to sustain consistent growth and achieve a higher ROE.
Limiting stock-specific risk
We believe it is important to limit exposure to any one stock in the portfolio. QLTY has a 2% single stock limit, meaning that at the time of a portfolio re-balance, no stock can have an allocated weight higher than 2%. This helps limit stock-specific risk and allows for a well-diversified portfolio of true-to-label quality companies.
Interested in finding out more?
You can view the current holdings of QLTY here (updated on a daily basis) along with other information about the Fund.