Time for quality control

14 June 2023 by National Bank Investments

Market uncertainties, increased volatility, and an economic slowdown have led many investors to rethink how they evaluate equities. In this context, quality factor investing has been gaining traction among professional money managers.

Understanding how quality factor works

In the world of investing, a factor corresponds to any characteristic that can help explain an asset’s long-term risk and return profile. Many characteristics come into play, including the asset’s value, momentum, size, or even quality. Stocks that are considered “quality” are generally comprised of companies that feature stable earnings, robust balance sheets, and consistent growth in comparison to lower quality stocks. During periods of market and economic uncertainties, quality companies can be less prone to interest rate risk because of their minor reliance on leverage. Given where the yield curve now stands and as capital becomes scarcer, money managers tend to prioritize these stocks which can be assessed by using Return on Equity (ROE) data.

Why quality now?

The current economic backdrop may prove favourable for quality. Historically, the quality factor tends to do well when economic growth slows, and long-term interest rates are on a downward trend. Both of these circumstances seem to be taking shape now. Empirical evidence shows that this has occurred in some of the most recent downturns, such as during the global financial crisis of 2008. (Rao, 2022) Indeed, as Chart 1 (below) illustrates, the quality factor has been one of the best performing and stable sources of equity alpha in the U.S. over the last 20 years.

U.S. Equity Factor – Cumulative Alpha (last 20 years)

Graphic U.S. Equity Factor vs Cumulative Alpha during the last 20 years

CIO Office (data via Refinitiv).

Furthermore, quality has become in vogue and has regained its luster since the beginning of this year. A trend that could continue as this supportive backdrop for quality stocks takes shape. (Chart 2)

U.S. quality factor performance vs manufacturing activity

CIO Office (data via Refinitiv).

Opportunity in quality

Quality companies are often better positioned to withstand declining economic environments. Companies with robust balance sheets, positive free cash flows, and sustained competitive advantages tend to be more resilient during these periods. Given the current landscape, exposure to high-quality stocks can potentially help investors weather uncertain market conditions over the long term.

Discover some of the NBI funds and ETFs with a quality factor exposure.

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