Will Quality rise to the top? - BetaShares

Will Quality rise to the top?

BY James Thompson | 18 August 2021
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The topic of inflation has been covered ad nauseam this year. Will it spike, prompting rate hikes from central banks? Or is it a transitory function of Covid-related supply bottlenecks and readjustments?

Looking through the noise of the debate, the pullback in U.S. 10-year bond yields in recent weeks indicates bond markets are telling us investors are positioning for slower than expected global growth.

Doubtless the growth vs value tug of war will continue. As the cycle matures, we could however see a rotation into high-quality equities as the market shifts focus to leadership, amidst the continued uncertainty.

In fact, more recently we have begun to see a divergence in performance between higher quality large-caps and more speculative U.S. growth names. For context, the chart below compares the performance for the first half of 2021, and for the month of July, of:

Factor performance YTD vs July

Morningstar as at 31 July 2021. Graph shows performance of iSTOXX MUTB Global ex-Australia Quality Leaders Index (which QLTY aims to track), not ETF performance and does not take into account ETF management costs. You cannot invest directly in an index. Past performance is not an indicator of future performance of Index or ETF.

Where is the money going?

After many months of flows favouring Value over Growth-tilted ETFs, that trend is showing signs of reversing, with the trend favouring cyclicals and industrials giving way to moves back into healthcare and tech in recent months. The easing back in bond yields has checked the relative performance of financials and favoured technology, and the quality factor has also begun to resume its pre-COVID trend of outperformance. Longer-term investors appear to be dialing up quality weightings.

What is Quality?

While investing in quality companies seems somewhat intuitive, there is no universally accepted definition of how quality should be measured. Quality investors pay attention to a range of criteria that they believe influences or explains a company’s business success. Chief among these are:

  • high profitability and capital efficiency
  • low financial leverage, and
  • high likelihood of earnings stability in the future.

The metrics used by various quality investors may differ slightly, but the end objective is generally the same – to construct a portfolio of stable, strongly profitable companies that are expected to perform over the long term and through the market cycle.

How has Quality performed during inflationary periods?

Over the last 100 years there have been eight periods where U.S. CPI exceeded 5% for a period of a year or longer. Quality Stocks outperformed the S&P 500 in six of the eight inflationary periods.

‘Quality Value’, which simply refers to companies exhibiting quality characteristics while also offering compelling relative value in terms of traditional accounting measures such as price to book, outperformed in seven of the eight periods.

Quality value

Source: GMO – https://www.gmo.com/australia/about-gmo/. You cannot invest directly in an index. Past performance is not an indicator of future performance of Index.

What makes Quality attractive in an inflationary environment?

  1. High profit margins – Quality companies exhibit high return on equity. This typically means their production generally has a high profit margin – their cost per unit of revenue is lower than that of the market, so they are naturally better protected from increases in production costs and should therefore be better placed than most businesses in an inflationary market to maintain high levels of profitability.
  2. Pricing power – High quality companies typically exhibit above average pricing power. It’s not unreasonable to assume that in an inflationary environment Quality companies, which in many cases exhibit a competitive advantage, would be able to raise their prices, absorbing any increases in the cost of production.
  3. Strong balance sheets – Quality companies have high levels of equity relative to debt. This means they are less affected by increasing costs of debt in a rising interest rate environment caused by inflation.
  4. Valuation risk – in a rising rate environment, one of the single biggest risks to equities is ‘valuation risk’. Companies with extreme valuations, or valuations based mostly on cashflows further out in future (i.e. growth companies that are currently not making a profit), would typically be hit harder due to the influence that a rising discount rate has in lowering the present value of forecast future cash flows.

BetaShares Global Quality Leaders ETF (ASX: QLTY)

QLTY has been specifically designed to provide investors with exposure to a diversified portfolio of global companies (ex-Australia) that demonstrate Quality characteristics, with the potential to deliver relatively high and sustainable returns on equity over time.

From a universe of 1800 stocks across global markets, the index which QLTY aims to track identifies the top 150 that each year achieve the highest quality scores based on their return on equity and profitability, low leverage and earnings stability measures. This approach leads to a portfolio of premium companies, many of which are household names.

In addition to profitability and financial health, a notable step in the methodology of the index that QLTY aims to track is Earnings Variability. Earnings Variability is crucial in an inflationary environment, as companies with inconsistent earnings are far more likely to be affected by an increase in the cost of production, and therefore harder hit by the economic cycle.

QLTY is currently the lowest-cost Quality factor global equity ETF traded on the ASX at 0.35% p.a.

Summary

While much has been written about growth vs value this year, few are talking about quality. The fact is no one is certain how the recovery will play out. Will we see a hot economy with high growth and inflation? Or a slower growth environment with the threat of inflation lurking in the shadows? It’s hard to predict. While many are taking bets and choosing a side, quality has the potential to outperform in both scenarios. For a long-term investor we believe it is worth considering as a core portfolio allocation.

There are risks associated with investment in QLTY, including market risk, index methodology risk, international investment risk, concentration risk and currency risk. For more information on risks and other features of QLTY, please see the Product Disclosure Statement, available at www.betashares.com.au.

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