With economic clouds gathering and markets showing heightened volatility, investors seeking stability over speculation may find quality stocks a potentially attractive option.
After several years outside the “Mag 7” spotlight, quality stocks may be poised for a significant revival. These businesses—characterized by superior capital efficiency, better earnings quality, and lower debt—have underperformed the past few years despite their reputation for resilience during uncertain market conditions.
What is Quality Investing?
Quality investing is a strategy that prioritizes companies with strong financial health, stability, and growth potential. It involves identifying firms with consistent profitability, robust balance sheets, and the ability to withstand economic downturns. Key characteristics of such quality companies include high profit margins, stable earnings, growth in earnings and dividends, efficient asset use, and low leverage.
Important metrics used to assess the quality of a company include Return on Equity (ROE), Gross Profit Margin, Earnings Volatility, and Debt-to-Equity Ratio. Ultimately, the quality investment strategy is focused on companies that offer profitability, stability, and strategic positioning for long-term success.
Historically, quality stocks have shown potential for outperformance, particularly during economic crises. A study by WhiteOak Capital AMC found that over five-year rolling periods since April 2005, the Nifty200 Quality 30 index strategy delivered returns exceeding 10% in 92% of observations, compared to just 71% for the Nifty 50 index. The quality index averaged 17.4% annualized returns versus 12.5% for the Nifty 50.
Why This May Be Quality’s Time
Quality businesses have underperformed over the past few years despite solid earnings, as the market favored tech-driven and cyclical companies. Yet, recent growing economic uncertainty may present an opportunity for a shift.
The recent market was primarily driven by companies with weaker earnings quality and slower growth, precisely the businesses most vulnerable during economic slowdowns. In contrast, quality companies typically have substantial competitive advantages and less reliance on external capital, allowing them to deliver more predictable growth during challenging times.
For investors, the recent underperformance of quality stocks may create an attractive entry point.
How to Invest in Quality
There are several potential options for investors interested in adding quality to their portfolio. Individual stocks have historically been the primary way investors have pursued the strategy. This approach may appeal if you prefer to get under the hood and enjoy filtering and researching investments.
Yet, ETFs have become a very popular investment tool, with factor or smart beta funds now making this strategy more accessible through rule-based portfolio construction. This approach can satisfy those who don’t want to necessarily do all the work to identify and select individual securities but still want to add an overlay of exposure to their portfolio. ETFs that implement quality investing include the iShares Edge MSCI USA Quality Factor ETF (QUAL), Invesco S&P 500® Quality ETF (SPHQ), and JPMorgan U.S. Quality Factor ETF (JQUA).
However, investors should note that, like any factor-driven strategy, quality will experience cycles of outperformance and underperformance. They work best as an addition to a well-diversified portfolio, especially given their current prospects in today’s increasingly uncertain market environment.