For many years now, we have had a strong bias towards the Quality style of investing within our clients’ portfolios and our house-view funds. Traditional quality fund managers will pick the stocks of companies that have a track record of consistent earnings growth, whilst maintaining healthy balance sheets throughout good and bad times. These quality companies will typically be market leaders, provide essential products and services that are consumed, and have competitive advantages (brands, intellectual property, scale, manufacturing efficiencies, etc.) that give them pricing power under all market conditions.
While traditional quality funds have mostly offered significant downside protection during periods of market turbulence in the past, there is no question though that, over the last two-and-a-half years or so, most quality funds have underperformed global equity benchmarks, where the outsized returns have been disproportionally driven by the AI boom. As one would expect, the tendency of quality managers to focus on consistent historical performance rather than short-term momentum, means that they have far less exposure to the more mercurial technology stocks that have ignited growth in recent years.
The very purpose of quality funds should, in fact, be to help investors reduce their exposure to the risky market concentrations that arise during market rallies. Since the emergence of Chat GPT into our everyday lives in 2023, we have seen massive growth in the valuations of the Magnificent Seven (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla). These tech-focused companies, with valuations ranging between around $700 billion to $3.3 trillion, now represent around a third of the S&P 500’s total market capitalisation. And quality managers have deliberately held underweight positions in these stocks.
Their approach, however, is designed to protect investors from severe volatility when stock markets are plummeting. When we look back at performances during the COVID-19 downturn and the 2022 market correction, which was caused by Russia’s invasion of Ukraine, it is fair to say that most quality managers did not really live up to the expectations. They did fall less than the MSCI in 2020, but not dramatically so, and they didn’t provide the anticipated defensiveness in 2022. This might be explained by just how short-lived those bumpy periods proved to be. All stocks, including quality companies, were sold off on significantly negative sentiment, but the recovery was generally so fast that the quality companies didn’t have the opportunity to prove their differentiated earnings’ resilience.
A litmus test awaits
We have now entered a phase that will serve as the next litmus test for quality managers. Trump’s return to the White House has been the catalyst for a market correction with fiscal and trade policies, geopolitical tensions, and even extraneous factors such as technological shifts, all introducing high levels of uncertainty for stock markets, especially in the US. Shares driven primarily by momentum had surged ahead of actual earnings, leading to concentrated market positions that are proving to be vulnerable to a shift in sentiment.
Implementation of new tariffs, the downsizing of the US Federal Workforce and aggressive anti-immigration policies could all impact inflation and economic growth in the US as well as globally in the months to come, in turn causing market corrections and sectoral selloffs. We would anticipate that the quality stocks should be less susceptible to the corrections, especially if the market has time to digest the resilience of their earnings and appreciate the fact that they are not expensive, having missed out on much of the prior upside momentum.
We will continue to monitor our quality managers’ performances very closely to see if they can justify their allocations by providing the downside protection that we would hope to see.
