Quality time – the case for quality stocks as recession fears rise

Key takeaways

• Equity investors face tough choices, as recessionary concerns and higher rates weigh on markets simultaneously; favouring different styles is one way to try and improve performance
• A tug of war between value and growth dominated the narrative last year. This year, rising rates have also dealt a bigger blow to higher growth segments of the market
• Quality stocks tend to outperform in challenging market environments, especially during slowdowns and cyclical recessions
• We have increasingly favoured a quality overlay this year, and recently upped the quality bias within our equity exposure.

Amid tough times for equities, a tilt towards quality can add a defensive element to portfolio positioning. We examine the case for quality stocks in the current bear market.

Equity investors are having a painful year. Major markets have fallen 10-25%, with double digit declines in the US, Europe, mainland China and much of the emerging world. Rising recessionary fears are compounding high inflation, a prolonged war in Ukraine and investors reducing risk exposures. This cycle is also unusual, with growth concerns and higher rates weighing on markets simultaneously, leaving few places for investors to hide.

The X Factor

Investors can try to improve performance by tilting their equity exposures towards different regions, sectors, or styles. Dispersion here can be significant, and has been high this year. Energy, for example, is the only sector to have delivered positive performance year-to-date, up 21.4% versus a 28.5% fall for consumer discretionary stocks¹. “Different ‘factors’, or investment ‘styles’ – including value, growth, quality, momentum and size (see text box at end of article) – can alter investments’ long-term risk and return performance and tend to exhibit different characteristics, e.g. volatility, rate sensitivity and performance across the cycle. In recent years, investment styles have been more important drivers of returns than sectors or regions, according to MSCI data².

A tug of war – value versus growth

For much of equity market history, the value style of investing – buying stocks that look cheap versus their intrinsic value – has been a favoured strategy. Yet between the Global Financial Crisis and 2021, growth stocks outperformed their value peers, and tech stocks rose inexorably, leading many to wonder if the world had fundamentally changed. In 2021, however, value stocks staged a comeback and gradually regained the ascendancy. This year, too, rising rates have dealt a bigger blow to higher growth segments of the market, although the spread in performance between value and growth has narrowed.

Style investors tend to focus on the value/growth dichotomy: is the initial price we pay for an investment, or its subsequent growth, the most important driver of returns? Yet there is another, less researched dimension: the quality factor. It has no single agreed definition. A quality label can be self-serving – no one wants to tell clients they invest in low-quality stocks. We define quality stocks as having high and stable profitability (return on equity, earnings variability) and low leverage. Academic research shows that stocks sorted on this basis have generated higher risk-adjusted returns than the broader market over time, with evidence for a profitability premium especially strong, particularly for large-cap firms³.

Crucially, quality tends to outperform in challenging market environments, especially during slowdowns and cyclical recessions, as these lead to a contraction in earnings and margins for most companies. US quality stocks have outperformed the broader market in the last three recessions (2001, 2008-2009 and early 2020 – see chart). Why is this the case? Quality companies tend to be those with strong business models and competitive advantages that rivals struggle to emulate. Many are multinationals, providing diversification across many economies. Their predictable earnings chug along, even as growth falls. This also allows them to continue paying dividends, providing investors with reliable income, which can be highly prized if bond yields are low. Quality firms also do better on balance in inflationary environments, since they are better able to defend their margins.

Examining Buffett’s success

Both quality and value investors seek strong earnings; the former with more emphasis on balance sheet health, the latter on valuation multiples. The two styles tend to work at slightly different points in the cycle: value in expansionary periods, when their multiples re-rate, and quality in recession. Warren Buffett is famous as a value investor, but an analysis of Berkshire Hathaway’s performance from 1977-2016 suggests that quality was actually a more important factor than value in generating the firm’s excess returns, contributing 3.4 percentage points of performance, versus 1.2 percentage points respectively⁴. A 2008 annual report from the investment firm generated a famous Buffett aphorism, which captures both elements: “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”