Quality companies possess characteristics that investors usually warm to, but this was totally different in 2022. In every quarter, the MSCI World Quality index lagged behind the MSCI World index, and in every quarter a loss was collected. On balance, it was lower-quality stocks that beat the market in 2022. A top five low-quality equity funds.
In search of safe havens, investors often flee to quality stocks. These robust companies are considered capable of mitigating storm damage thanks to their dominant market position, proven business models and strong balance sheet. In 2018, for example, the MSCI World Quality index lost just 0.74 per cent, compared to a loss of over 4 per cent for the MSCI World index.
In 2011, the quality index plus over 7 per cent, outperforming the broader market by over 9 percentage points, and even at the time of the great financial crisis in 2008, high-quality stocks managed to cushion losses somewhat. Not so in 2022, when inflationary and interest-rate fears shook the market and quality stocks generally failed to provide their characteristic protection this time around. The MSCI World Quality index incurs a loss of nearly 13 per cent bringing its underperformance relative to the MSCI World index to about 4 percentage points.
Quality companies, as long as the valuation is reasonable, are ideally seen as the ideal buy-and-hold stocks in an investment portfolio. A solid core of mature companies that have proven throughout their long history that they can take a beating. Perhaps not always adventurous, but a reliable component that adds resilience to the portfolio.
MSCI World Quality index behind
There is no single definition of quality, but measures or characteristics attributed to these companies include high return on equity, high net profit margin, stable earnings growth and conservative financing. These superior characteristics are based on a sustainable competitive advantage due to economies of scale, network effects, intangible assets or cost advantages, with the execution of the business plan in the hands of a competent management team. Conspicuously absent from this list is the competitive advantage that can be obtained on the basis of superior technology.
While technological innovation can give a company an edge, the durability of that technological edge is becoming shorter and shorter, making a sustained competitive advantage more difficult to achieve as a result. It is one reason why the managers of the GuardCap Global Equity Fund, for example, never considered investing in Apple.
While the company has a string of (groundbreaking) product introductions to its credit, the team argues that Apple is ultimately a consumer electronics manufacturer and that history has countless examples of companies that saw a (long-term) technological lead disappear when another revolutionary product was introduced by a competitor. Think, for example, of how the dominance of Nokia or BlackBerry was eroded.
Despite quality companies possessing characteristics that investors usually warm to, this was completely different in 2022. In every quarter, the MSCI World Quality index lagged behind the MSCI World index, and every quarter saw losses. The disappointing performance of quality stocks can be attributed to the growth nature of the index and the dominance of technology companies and the lack of energy stocks that performed by far the best this year. Software, hardware and semiconductor companies, including index heavyweights Apple, Microsoft, NVIDIA and ASML are having a disappointing year.
However, it does not mean that investors who prefer quality are ignoring these stocks, quite the contrary. For instance, the managers of Maj Invest Global Value Equities are very positive about the semiconductor industry and have built positions in KLA, Teradyne and Micron Technology, among others, over the past 12 months. Stuart Rhodes, manager of M&G Global Dividend, also took advantage of the price pressure to upgrade the quality and growth potential of his portfolio, buying positions in KLA, ASML and Broadcom.
Lower quality beats the market in 2022
Although the underperformance of quality stocks this year offers opportunities to strengthen the core of the portfolio, on balance it is the lower quality stocks that beat the market. This week’s top five is therefore compiled based on Morningstar’s Risk Model Factor Profile score for funds in the Global Large-Cap Mixed Equity category. The quality factor is based on a company’s profitability and financial leverage.
The return on equity over a 12-month period and the debt-to-equity ratio are central to this. A percentile score of 1 represents high quality, while 100 represents low quality.
Amundi Pioneer Global Equity tops the list with a score of 79.3. The fund therefore has a stronger penchant for value stocks than the average competitor in the category. Its exposure to companies with a sustainable competitive advantage, so-called wide-moat companies, is only 15 per cent. That is much less than the category average of 47 per cent and 38 per cent for the index. Also, companies in this portfolio are more often financed with debt, as evidenced by the debt/capital ratio of 43 per cent, which is four percentage points higher than that of the index.
On factors such as profitability and return on invested capital, the portfolio also scores markedly lower. The portfolio houses more financial securities, while the weighting of energy stocks is more than twice that for the category average. Exposure to these types of companies helped the strategy in 2022, as it can present a positive return of 2.2 per cent.
Top 5 (NL)
Top 5 (B)
Jeffrey Schumacher is director manager research at Morningstar. Morningstar analyses and evaluates investment funds based on quantitative and qualitative research. Morningstar is one of Investment Officer’s knowledge partners and ranks five mutual funds or providers every week.
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