At Dynasty, we’ve traditionally had a strong bias towards ‘quality’ in our clients’ global equity portfolios. In brief, the quality investment style favours stocks with strong balance sheets, stable earnings, and high returns on equity. Such companies have strong heritage brands, substantial pricing power, credible management teams, and operate in sectors with high barriers to entry.
For years, investing in quality has paid off because such companies could deliver predictable earnings during market downturns and times of volatility. However, as Chris Cheetham, the Head of Global Research at Coronation Fund Managers, argues in a recent opinion piece, the definition of quality needs a rethink in today’s rapidly changing and dynamic world, Chris writes:
“Looking back at history, companies that tick these boxes have understandably received a lot of interest from investors. Many are household names with strong brands, and their products are often defensive, with ongoing demand irrespective of macroeconomic conditions. These businesses all boast very healthy returns on invested capital, in some cases well north of the 20% mark. This all sounds great on paper, yet many of these names have performed very poorly versus the MSCI All Country World Index (MSCI ACWI) benchmark over the last five years, with some even being down heavily in absolute terms.”
This is a trend that we have also noted, as recently pointed out in our newsletter headed “A new lens on inflation”. Over the past five years, technological disruptions, changing consumer behaviours, and geopolitical volatility have challenged long-held assumptions. Quality companies in sectors such as luxury goods, consumer staples, and FMCG have struggled to retain margins and outperform broad indices during unprecedented times.
Quality stocks vs. indices
Indeed, the MSCI World and S&P 500 indices have handily beaten most quality managers since Microsoft invested $10 billion in OpenAI in January 2023 to catapult ChatGPT into the mainstream. This pivot into AI and Big Tech has meant that some bellwether quality stocks have not only struggled to compete on revenue growth and earnings growth, but they are so out of favour that they have even lost value in absolute terms, stretching out to five years.
The table below from Chris Cheetham breaks it down:
There are a few factors at play that bear consideration. Many of the stocks favoured in quality portfolios are battling to navigate sea-changes in consumer behaviour, the macroeconomic environment, and the competitive landscape. For instance, consumer research shows that many people are trading down from major brands due to the high cost of living, especially in a world where white label retail goods no longer have the low-quality stigma they did in the past. This is happening at the same time as producers’ input costs are rising.
Meanwhile, some companies have been left behind by consumers adopting healthier and more natural alternatives to the established brands. The increased use of GLP-1 weight-loss drugs means that some people are eating less packaged and processed food. Among younger people, many drink less alcohol than their parents did at the same age, buy second-hand goods where possible, and choose to spend money on experiences rather than consumer goods. This all prompts a rethink of traditional quality investing.
While we would expect our quality managers to anticipate these trends and adjust accordingly, it is often the case that they are hamstrung by their predefined mandates and cannot deviate from their specified investment style. In addition, it is worth noting that the broad indices reflect a heavier exposure to the technology sector than most quality managers and risk management protocols might prohibit them from being as highly exposed as the MSCI.
While valuations of AI-driven stocks are starting to look frothy, an outsized portion of the growth we have seen in the past five years has come from a handful of Big Tech stocks. Based on our own research at Dynasty, the earnings reports from the tech companies in the last quarter, and the unwavering commitment from the Big Tech CEOs to keep spending, we believe that this may not be a short-term aberration, but that the cycle may have further legs or even be a deeper structural shift.
Adapting our portfolio philosophy for disruption and change
In this context, we have spent the last two months evaluating the rebalancing of our portfolios and house-view funds to accommodate a further-changing world. While many quality metrics still apply and the performances of our quality funds and instruments have not lost value like some of the above-listed stocks, the opportunity cost has increased, and we are thus looking at an approach that unlocks more growth without unduly increasing risk, especially when measured against the benchmark.
As a small example, Research Enhanced Indexing (REI) funds will become a component of our evolving philosophy for our house view portfolios. Such funds represent a combination between passive index tracking and active stock-picking, with the objective to outperform the MSCI net after fees and without deviating very far from the index weightings at any point. This gives the fund management teams some leeway to select stocks with a view to outperforming the market, but it also means that funds should generally keep up with the broader indices. Indeed, the track records of our two selected REI funds have exceeded that of the MSCI over the last 5 years, despite the challenging environment described above.
In our revised portfolio construction, instruments that track broad market indices combined with an allocation to REI funds will become the ‘core’, which we will ‘satellite’ with selected active funds or thematic ETFs. We believe our evolved philosophy represents a defendable approach to delivering consistent, risk-adjusted returns at a time of ongoing structural change and deep disruption.
At the same time, we recognise that some clients will still find a level of comfort in traditional quality funds and will want to retain them as a key component of their direct portfolios – a principle we will workshop with each client in the course of the next few months.
