The sell-off in equity markets this year has many investors naturally looking for a defensive strategy. One such option is to shift into quality companies to ride out the turmoil. It sounds simple, but is it really?

As equity markets struggle in the face of higher interest rates and a growing threat of recession, a key solution for investors is to seek out genuine high-quality stocks that are going to prosper despite the downward turn in the market cycle.

Investing in quality might sound obvious, but behind the simple description lies a wide variety of opinion and evidence on how to determine which company really fits the description.

A research paper written by Jason Hsu, Vitali Kalesnik and Engin Kose in 2018 entitled ‘What is Quality?’ found that for a true long-term return premium, evidence suggests the best returns are from companies which offer a combination of profitability with solid investment characteristics.

The research also suggested companies displaying characteristics of profitability, accounting quality, payout/dilution and investment delivered superior performances.

But surprisingly, the authors found delivering earnings stability, capital structure and growth in profitability showed no robust evidence of producing a premium return on the market.

Quality Investing on a growth path

Quality as an investing concept can be traced back to Benjamin Graham and his 1949 book ‘The Intelligent Investor’. It became more popular around the early 2000s following the bursting of the dotcom bubble and other spectacular failures like U.S. energy company Enron and telephone group WorldCom.

It is also associated with Warren Buffet and his giant conglomerate, the Berkshire Hathaway Group, which invests in a diversified group of major brands based on a qualitative investment approach. Buffet has said investors should only buy stocks in companies that exhibit solid fundamentals, strong earnings power, and the potential for continued growth.

An academic study by Andrea Frazzini, David Kabiller and Lasse Heje Pedersen found Warren Buffett’s focus on buying high-quality stocks largely explains the performance of the listed stock portfolio held by Berkshire Hathaway, which from 1965 through the end of 2021, generated a compound annual return of 20.1% against 10.5% for the S&P 500.

Defining a quality stock

Generally quality investing is defined as investing in stocks which have higher return on equity (ROE), sustainable earnings and low financial leverage. It has historically been a go to strategy for those astute investors seeking long-term outperformance.

More specifically, quality stocks can be assessed as having three key characteristics:

• Profitability – Particularly return on equity, cash flow generation and the margins of the business – which measure the ability of the company to generate profits from its assets.
• Stability – This requires an analysis of the likely growth of dividends, the stability of cash flows, earnings, and sales over time. There are other factors as well, such as capital expenditure, the ratio of investment to assets and recent asset growth, to name a few.
• Financial Strength – Companies with modest leverage and an ample ability to service that debt with some cash in the bank are better placed to manage slowdowns in the macroeconomic environment.

There is no great consensus as to which of these measures is the most appropriate or provides the best results. However what the research does agree on is that quality stocks have historically outperformed the market, with relatively low volatility, over long time periods. A portfolio of quality stocks produces better risk-adjusted returns over time than the market average.

As a result, in recent years MSCI, FTSE Russell, and S&P, among others, have created quality smart beta indices and have typically included quality as part of their multi-factor offerings.

But, according to the research by Hsu, Kalesnik and Engine Kose, cited above, the lack of a consistent definition of quality, combined with the evidence that the components used to determine quality vary from having a strong impact to no statistically significant impact, means that how an index is constructed will have a major impact on how it performs as a quality factor.

In particular, the authors found earnings stability, capital structure and growth in profitability had minimal, if any, impact on generating superior returns from a quality investment strategy.

How to invest

On the ASX, there are many firms that might meet the definition of quality, and some that are regularly mentioned by analysts are Macquarie Group (ASX: MQG), CSL (ASX: CSL), Woolworths Group (ASX: WOW) and Wesfarmers (ASX: WES).

Obviously there is a lot of work involved in assessing the company accounts of listed firms to create a portfolio of top-quality stocks. However, as is often the case, there is the potential of using an ETF (Exchange Traded Fund) where product issuers use their own metrics to assess quality.

One such quality-focused ETF for shares listed on the ASX is the BetaShares Australian Quality ETF (ASX: AQLT). For a more globally focused portfolio, there are the BetaShares Global Quality Leaders ETF (ASX: QLTY).

VanEck also offers the MSCI World ex-Australia Quality ETF (ASX: QUAL); along with the VanEck MSCI International Quality (Hedged) ETF (ASX:QHAL), the VanEck MSCI International Small Companies Quality ETF (ASX:QSML), and the Australian VanEck Small Companies Masters ETF (ASX:MVS).

There is also the SPDR MSCI World Quality Mix ETF (ASX: QMIX).

The BetaShares Australian Quality ETF offers a portfolio of 40 of Australia’s highest quality companies, which are all ASX-listed companies that have high return on equity, low leverage, and relative earnings stability.

“Rather than just weight stocks by their market capitalisation, AQLT offers exposure to companies with a high ‘composite quality score,’ which is based on key financial metrics such as return-on-equity, debt-to-equity, and relative earnings stability over the last five years,” said Blair Modica, Director, Adviser Business, at ETF provider BetaShares. 

“The underlying index for AQLT is rebalanced annually so investors can be sure the fund is true-to-label and remains invested in quality Australian companies,” he added.

VanEck’s QUAL ETF gives investors exposure to a diversified portfolio of quality international companies listed on exchanges in developed markets around the world outside of Australia.

The QUAL ETF has returned 14.37% p.a. since inception to 27 July 2022, outperforming the MSCI World ex Australia Index by 2.61% p.a. Investors have noticed with AUSIEX data showing that the VanEck’s QUAL ETF was the second most actively traded ETF at the end of July 2022, having been as low as ninth in June 2021.

“With increasing talk of a recession, the QUAL ETF selects companies based on key fundamentals that make up a quality score, which takes into account low financial leverage, earnings stability across the cycle and return on equity and has demonstratable historical outperformance during periods of economic slowdowns,” said Nick Jackson, Director – Business Development at VanEck.

Detailed analysis is key

As an investment strategy in a period of uncertainty, building a quality portfolio seems an obvious choice, but it is important to understand that not all products labelled ‘quality’ will be alike.

The large variety of methods for constructing a quality index and the different interpretations of the term mean that an investor needs to understand the detail of the product’s approach to quality assessment before making an investment decision.

¹Hsu, Jason C. and Hsu, Jason C. and Kalesnik, Vitali and Kose, Engin, What Is Quality? (July 11, 2018). Financial Analysts Journal, vol. 75, no. 2 (Second Quarter 2019): SSRN: https://ssrn.com/abstract=2971185 or http://dx.doi.org/10.2139/ssrn.2971185

²Buffet’s Alpha - https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3197185