May 2024 / EQUITY
The quality factor: Its impact, foundation, and evolution
Secular components have become an important part of quality investing
Key Insights
- Quality has been a powerful driver of returns, in part, given its relationship to the consistency and compounding of shareholder returns.
- An assessment of quality should center on financial analysis to help understand corporate health; financial productivity; and a company’s competitiveness, management execution, and shareholder returns.
- Quality is increasingly being influenced by a company’s exposure to secular change. Companies aligned with long‑term, sustainable growth trends appear to be economically more resilient and fundamentally of higher quality.
The investment landscape of the last 18 months has been unusual in many respects. Looking back, much of the rally has been driven by risk aversion easing back as black swan events were either avoided or diluted in probability. But while headline equity market returns might imply a robust economic backdrop, index returns were achieved despite an economic deceleration—but also because of a heavy concentration in a handful of stocks, most notably, the “Magnificent Seven"1 (Figure 1). While these stocks might be loosely bonded by the emerging theme of artificial intelligence (AI) and its infrastructure and future applications, the extreme return concentration over that period merits deeper consideration.
Magnificent Seven ride to the rescue
(Fig. 1) 2023 market returns were dominated by a handful of stocks
The market capitalization of the Magnificent Seven stocks is one clear linkage, but a key thread when looking at equity returns over the past decade has been a collective improvement in the quality of these companies. This show of quality intertwined with the expectation of future growth and improvement, and stemming from the AI revolution, is at the heart of why these companies have dominated equity returns.
What is quality, and does it work?
Factor definitions—including size, momentum, volatility, growth, and value—have long been viewed with a high degree of consensus among practitioners and academic researchers. While there are variations in the precise metrics used for definition, many factor concepts are widely accepted and understood by investors.
Quality, either as a factor or as an investing style, is a notion that lacks a universally agreed‑upon definition, however. This makes quality harder to identify and capture, despite strong consensus and evidence that it has strong linkages to financial returns within equity markets.
We examined quality from both a quantitative and qualitative perspective with a goal to understand its foundations, its impact on returns, and its redistribution in an ever‑increasing digital world. As a starting point to understand why quality is a much‑debated concept, we compared the MSCI ACWI2 with the MSCI ACWI Quality (Figure 2). While there are many definitions available, the MSCI ACWI Quality aims to capture the performance of quality‑growth stocks by identifying securities with high quality scores based on three main fundamental variables: high return on equity (ROE), earnings stability, and low financial leverage.3
Quality stocks have outperformed for over 10 years
(Fig. 2) The last few years have seen a clear differentiator in performance of quality assets
Outperformance of the quality index is notable, even more so when considering the five‑year rolling relative return of the quality index, which exceeds its mainstream equivalent in 85% of observations since 1997 (Figure 3). At least through the lens of one index definition, quality has been a consistent outperformer, albeit with cyclicality and notable periods of drawdown.
Long‑term outperformance of quality assets
(Fig. 3) Five‑year rolling relative returns of the quality index have exceeded its mainstream equivalent in 85% of observations since 1997
This cyclicality is better observed through an evaluation of shorter‑term data. In Figure 4, we show the same analysis over a rolling six‑month time frame, observing that the quality index often experienced underperformance during extreme risk‑on periods. These have often followed in the wake of crisis‑type events. This pattern is intuitive given that such recovery periods are often defined by broad‑based improvement and high‑risk tolerance. The exit from the financial crisis of 2008–2009 and the reopening of the global economy following the COVID‑19 pandemic are two such examples of quality underperformance.
Risk attitudes define quality asset cycles
(Fig. 4) Quality often experiences underperformance during extreme risk‑on periods
With each observation representing six‑month periods rolled one month forward, we found that in 65% of observations, the MSCI ACWI Quality produced positive excess return relative to the MSCI ACWI. Midcycle and/or less directional markets are where quality tends to deliver a return advantage, especially where a scarcity component emerges. This growth scarcity was evident in 2023, and also in the period preceding the pandemic, where economic and earnings growth were muted. As with any scarce commodity, as growth becomes harder to come by, investors are more willing to pay a premium.
The more recent outperformance of quality has been driven by the absence of broad economic and earnings growth, in tandem with a concentration of earnings growth centered on the Magnificent Seven (Figure 5), a group of stocks that has risen in significance for quality investors.
Robust reasons for outperformance of the Magnificent Seven
(Fig. 5) Since the pandemic, earnings growth has been markedly better than for other styles
The foundations of quality
We believe there is no static definition to fully isolate “quality” given the constant evolution of economic, secular, and competitive factors that drive change within sectors and across equity cycles. While quality (alongside value and growth) is evolutionary, it is nevertheless critical to evaluate where stock fundamentals imply dimensions of quality and how this may have strong efficacy for future returns.
To demonstrate this point, we focused on the history of U.S. equity markets by evaluating the long‑term compounded returns of the S&P 1500 Index4 (sector neutral) since 1985. Our approach aimed to give a perspective on the importance of capturing the correct definition of quality and how investors reward differing capital allocation decisions, including reinvestment for future growth, versus the return of capital via dividends.
We grouped potential characteristics into the following two broad groups using sector neutral quintile analysis.
Profitability measures and economic efficacy
One of the pillars of quality focuses on profitability metrics and measures of economic productivity, including return on equity and return on invested capital (ROIC). Considering the S&P 1500 on a sector neutral basis since 1985, we found that companies with high cash flow yield had been the dominant driver of returns within measures of profitability and financial productivity.
High ROE, ROIC, and return on assets (ROA) also appeared to perform well, albeit profit margin indicators do not appear to have strong efficacy on a standalone basis (Figure 6). This provides insight into how investors prefer the singular measure of corporate economic success that cannot be materially influenced by accounting practices—free cash flow.
Companies with higher ROE, ROIC, and ROA tended to shine
(Fig. 6) Companies with high free cash flow performed best
Leverage and debt service
Another component of quality often cited in quantitative and fundamental literature centers on low or sustainable corporate leverage. While leverage and balance sheet sustainability influence the assessment of quality characteristics and corporate outcomes, including free cash flow generation, leverage alone is not sufficient to capture a full perspective on quality.
High debt coverage and interest coverage are far better predictors of prospective returns over the long term versus low or absolute measures of leverage (Figure 7). This perspective links closely to the performance of companies that are defined by debt sustainability, especially through crises—financial or otherwise— and the preparedness of balance sheets for changes in financing conditions, as we saw in 2023.
Quality companies with high debt coverage can be good predictors of returns
(Fig. 7) Companies with high debt and interest coverage outperformed companies with low absolute measures of leverage
While robust fundamental analysis would always incorporate an assessment of a company’s balance sheet and profitability, one clear observation is the potential tailwind that exists when focusing a portfolio on companies with high quality markers. Another way to look at the data is to consider the hit rate of individual factors by analyzing the frequency of outperformance. While affirming the benefits of high free cash flow and debt sustainability, Figure 8 demonstrates that negative earnings, sales volatility, and high levels of debt to equity were headwinds to return generation. This is intuitive given the drawdown that such stocks experienced during times of economic or industry‑specific downturn or stress.
Free cash flow yield is key
(Fig. 8) Stocks with negative earnings and lower debt to equity have underperformed
The Magnificent Seven and evolution of quality
The investment landscape of the last year and a half has been unusual in many respects. Despite strong headline equity returns, a complex macroeconomic backdrop persisted throughout the year encompassing:
- Extreme and unpredictable inflation
- Heightened geopolitical tensions
- Bank failures, albeit without any meaningful credit or unemployment cycle
- Anemic global economic and earnings growth—excluding the Magnificent Seven
While uncertainty abounded, the Magnificent Seven emerged as an economic force that helped equity markets push through these meaningful economic challenges. One of the clear reasons for the strong performance was the evolution of their individual and collective quality fundamentals. While each company has been through significant evolution and profitability cycles in the age of digitization, more recently, we have witnessed a marked decrease in earnings variability coupled with significant enhancements in profitability and investment quality (Figure 9).
The evolution of the Magnificent Seven
(Fig. 9) Investment quality, earnings, and profitability have all improved for this select group of companies
In addition, the earnings quality5 of these firms has witnessed improvement to the upper end of the range in recent quarters as disruptive concepts have evolved into established and more profitable businesses. This evolution has adjusted interest in these types of companies to a broader range of investors, including those seeking qualitative or quantitative quality exposure.
Considering the individual characteristics of stocks like Meta and NVIDIA, it is clear to see the change in the fundamental profile from a quality lens. While the drivers of these two stocks have very different origins, the inflection in their free cash flow profiles in 2023 is a clear and dominant force (Figure 10). This is especially notable given that the average company saw its economics and balance sheet squeezed by higher interest rates, while free cash flow levels were challenged by a combination of higher inflation and economic deceleration.
Rise in free cash flow is more likely to be rewarded by markets
(Fig. 10) Inflection point in free cash flow for Meta and NVIDIA
The driving force behind this evolution can be attributed to one component of quality assessment that is less widely recognized: exposure to secular trends. The changing nature of the global economy has been a driving force in the emergence and evolution of digital champions, not as concept, but as dominant in their industries and historically profitable cash flow generators. In many respects, this has reshaped the fundamental characteristics of growth investing, broadening out the opportunity set and economic maturity/profitability of the growth index (Figure 11).
Robust reasons why growth has outperformed value
(Fig. 11) Clear difference in earnings‑per‑share and free cash flow helped drive growth outperformance
While the trend of digitization redistributing profits and free cash flow to growth champions has been playing out for many years, an upswing in profitability, coalescing with the beginning of the AI infrastructure cycle, has seen the dimensions of quality evolve. We expect the addition of secular components to become an important part of quality investing going forward, and investors should factor this in to their portfolio construction.
Past performance is not a reliable indicator of future performance.
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May 2024 / FIXED INCOME