Market Musings 141023
The Quest for Quality

Summary:

• The Benefits of Quality over the long run

• Yes to Quality, but watch the price to pay

• Perhaps focus on sectors outside of Tech

• Approaches in Quality investing

Podcast this week:
Our investment strategy for October 2023

In this podcast Edmund Shing, Global Chief Investment Officer of BNP Paribas Wealth Management unveils his investment strategy for October 2023.

The Benefits of Quality over the long run

Much has been said about the advantages of investing with a quality mindset. Warren Buffett, one of the most celebrated investors in the world, is an avowed investor of quality stocks.There are many other investors who have been also celebrated for taking an explicit quality approach to investing in stocks such as Terry Smith, the founder and fund manager of Fundsmith.

First of all, what even is quality? The easiest definition of a quality stock is one which has:

• higher than average profitability that is sustained over a long period of time, together with

• relatively low levels of debt, or even net cash.

This can encompass a wide range of industries of course, but industries that come to mind as being dominated by quality stocks include

• Healthcare,

• Luxury Goods,

• Cosmetics,

• Premium drinks,

As well as selected monopolies and oligopolies, and technology

Essentially, we are looking for business models that can sustain higher than average profitability over a long period of time, together with reasonable or even strong growth levels. This depends in part on the quality of management, but perhaps more on the industry and the business model.

This is one reason why quality companies are often companies that have a very strong bond and image with their clients.

For instance, in the celebrated case of Costco, this food retailer tends to benefit its customers through low prices and in turn reinforces their loyalty, which ultimately reinforces the quality and growth trajectory of the company.

If we study the quality factor at work in stock markets, which can be done by using ETFs and indices that are based on the quality factor combining high profitability and low debt, you tend to find that you get better returns than for the overall stock market together with modestly lower risk.

SInce late 2016, the MSCI World Quality ETF has returned 11.6% per year on average (in euros), versus 10.7% CAGR for the broad MSCI World index, so a decent improvement over time that has resulted in a +115% return versus +104% cumulatively over this period.

Global Quality stocks have beaten the overall stock market

Source: tradingview.com

Yes to Quality, but watch the price to pay

So comparing risk to return, the quality investment style looks very attractive for the majority of investors. Of course, the key, as with all things, is not to overpay.

The key worry I would have with the so-called quality stocks that are The Magnificent Seven mega-cap technology stocks, is not over their business models, but rather over their valuations. Currently,they trade at around 30x P/E today which is expensive by anyone's standards.

In many ways, I would prefer to look beyond technology for quality today. I believe that investors sometimes forget how short technology cycles can be, and also how new disruptive technologies can emerge to disrupt existing oligopolistic or even monopolistic companies.

I think back to the Y2K tech bubble of 2000, for instance, and the example of Cisco Systems. Back in the year 2000, Cisco was one of the biggest companies in the world, but subsequently suffered a very sharp fall in subsequent years post 2000.

Cisco and Nasdaq in 2000: Huge bubble and then bust

Source: tradingview.com

Clearly, its growth and monopolistic or oligopolistic positioning was not as strong as people have believed.

Additionally, perhaps the demand for IT networking equipment was perhaps more cyclical and less stable than investors believed at the time.

Equally we could talk about Nokia, which was also one of the biggest companies in the world in the year 2000. By 2006. Nokia had amassed a 44% global market share in mobile phones. But we know what happened next, the advent of the smartphone and most importantly the iPhone in 2007 for the first time effectively ended this dominant position.

Nokia today doesn't even make handsets anymore. The point here is simply that technology cycles can be shorter than you think - new disruptive technologies can emerge faster than you think.

So predicting which tech companies can maintain a long-term quality track record of high profitability is pretty difficult. From the year 2000, I would say the only mega-cap tech company really to successfully maintain such a dominant position has been Microsoft - others such as IBM have not been able to copy this feat.

Perhaps focus on sectors outside of Tech

So I would rather look to other sectors where I believe we have a better chance of predicting long term quality. Luxury goods, for instance, play on people's vanity and I believe that's something that never disappears. Luxury goods also encompass, together with premium spirits, premium pricing and profit margins on the back of reliably high quality products, a fact that is widely recognized by the end client.

Good performance from Luxury Goods and Healthcare over the long haul

Source: tradingview.com

Healthcare similarly can be argued to have a strong quality position because of the high level of research and development plus patents that exist within the industry, particularly for pharmaceuticals. These “moats” allow companies to build up strong positions of high profitability once they own blockbuster drugs, which enjoy patent protection for many years.

The best current example of this clearly is Novo Nordisk, the Danish company which produces diabetes treatments, notably insulin, but now has seen explosive growth thanks to its diabetes treatment Wegovy, which is now marketed for weight loss as Ozempic and is enjoying fabulous growth in what is a very large total addressable market, potentially.

But there are many other areas of quality that we should examine. The notion of pricing power is important, as is the notion of an oligopolistic position in a given market. Stock Exchange operators such as LSEG (London Stock Exchange) fulfil this, as do financial service companies that produce indices such as MSCI or Standard & Poors for instance. These companies have demonstrated high profitability over many years due to the strong brand names that they enjoy, which gives them a form of oligopolistic positioning within the fast-growing area of indices, which underlie exchange traded funds.

Approaches in Quality investing

There are different ways to invest in quality. Firstly, you can pick your own stocks and naturally, this would lead you to focus on a number of companies in a number of sectors, such as perhaps technology, but more importantly luxury goods, healthcare, premium spirits, stock exchanges, index providers, and so on.

Or you could simply invest in a fund or exchange traded fund that invests explicitly in quality stocks. Many people for instance like to invest in the FundSmith range of funds for this approach. Although one should note that Fundsmith has a very explicit bias currently towards large cap US tech stocks, which of course has served it well, but has a very particular bias which you may or may not want to take.

Otherwise, there are quality factor exchange traded funds from iShares, Amundi and xTrackers that track world or European quality factor indices. These ETFs invest in quality on a quantitative basis, using the factors of high profitability such as high return on capital and low debt or net cash.

Both of these approaches have been relatively successful over the medium term over the last few years. Typically, if we look at a quality factor ETF based on an underlying index, you tend to find in Europe or globally that these ETFs tend to slightly outperform during bull markets. More importantly, they also tend to lose a little bit less than the overall stock market in percentage terms during bear markets. Hence this is why when you take a long period including both bull and bear markets together, you tend to find outperformance of these quality factor ETFs and indices over the overall stock market

Hence, for most investors who want to sleep soundly at night, but do want to invest in the stock market, I would argue that investing explicitly in either a quality factor ETF or a quality based stock fund like Fundsmith makes a lot of sense, because of these better than average risk return characteristics.

It won’t protect you clearly from negative performance during a bear market. But it should help to cushion the blow somewhat; and note that in the following bull market, you should regain your losses even quicker than for the stock market overall.

Today you have plenty of choice in quality funds. Global quality funds typically have a very big US bias right now, as is typical indeed for the overall stock market, with the US representing more than two thirds of the MSCI World Index at the moment.

European quality funds clearly have a bigger bias to sectors such as branded goods and healthcare rather than technology, as is the case with the global funds but are still relatively attractive. Because not only do you invest in quality, but you also invest in what I consider to be a relatively cheap stock market versus for instance, the US right now.

In conclusion, I would urge you all to invest in quality either through your stock picking by focusing on companies with sustainably high profitability in terms of operating margin and return on capital, but also with relatively low debt or net cash, which should underline the fact that quality companies also tend to be strong and reliable. free cash flow generators over time.

One twist on the quality factor is also to invest in dividend quality and dividend growth. And this can also be done by funds and ETFs. This ensures a steady level of income, but generally an income that can also grow steadily over time.

Have a great week,

Edmund