• VanEck analysis shows the quality factor outperformed the broader market in March during volatility
  • Quality is categorised as a defensive factor, meaning it has tended to benefit economic contraction
  • Return on equity, debt to equity and earnings stability are three signs commonly associated with quality

VanEck said investors should turn their attention towards quality as tough market conditions persist and a US recession becomes more likely following the recent banking crisis.

Analysis from VanEck shows the quality factor outperformed the broader market in March and is well placed to continue its strong performance despite the growing risk of an economic downturn this year.

VanEck Asia-Pacific managing director Arian Neiron said continued inflation and interest rate hikes plus collapse of overseas banks in March has provided a further boost to quality stocks, as lower yields increase the relative appeal of long-term corporate earnings.

“Quality screening targets companies in each sector of the market with low financial leverage, high return on equity and earnings stability,” he said

He said the tilt towards low financial leverage means refinancing risk is lower “and quality is underweight banks and real estate.”

“The VanEck MSCI International Quality ETF (ASX:QUAL) jumped by 7.58% in March 2023 compared to a 3.88% increase from the MSCI World Ex Australia index and a 0.16% fall for the ASX over the month.”

“A slowing economy, with falling inflation, at the end of a rate hike cycle should see the quality factor come to the fore,” he said.

“In the past, in this type of macro environment, companies with strong balance sheets, stable earnings and high return on equity, which are all quality characteristics, have outperformed.”

Neiron said quality was the standout factor between the global financial crisis and emergence of COVID-19 during an era of falling inflation and stagnant economic growth.

The stage is set for a repeat of this environment in 2023, and we expect the quality factor to outperform.”


Quality historically outperforms following a rate hiking cycle

Source: FactSet, Bloomberg , VanEckas at 24 March 2023.


VanEck forecasts earnings downgrades

Neiron said US Federal Reserve is trying to sidestep more repercussions from the disorder within the banking system while at the same time attempting to push down inflation.

“Our view is that earnings downgrades are likely to come through as developed economies navigate further recession risk as a result of the banking crisis,” he said.

“In this type of environment investors need to position their portfolios defensively and turn to quality names to ride out the storm.

“Based on the current inversion of the curve, as reflected by the 10- and 2-year yields, a US recession is priced in as a probable scenario later this year, especially given the recent banking crisis, rapid succession of central bank policy rate hikes and the Fed’s commitment to curb inflation.”

Neiron said that quality historically outperformed most during a contraction and subsequent recovery. As a result of these performance characteristics, the quality factor has earned the reputation as being a ‘defensive factor’.

“We believe the ‘quality’ factor will be dominant and over the long term and persistent across the cycle, our investment thesis has long supported the view that quality outperforms over the longer term,” he said.

Quality factor performance during various economic regimes

Source: ISM,MSCL, Bloomberg, VanEck. Quality is MSCL World Quality Index. Inception date December 31, 1998.


Three signs you’re about to invest in quality

A focus on high ‘quality’ companies has been the goal of many fundamental investors including Benjamin Graham and Warren Buffet.

Neiron said while definitions vary, quality is commonly associated with a company’s return on equity, debt to equity ratio and earnings variability.


1. Return on equity

Nieron said a company’s return on equity (ROE) is how effectively it uses investments to generate earnings growth.

“On its own the calculation won’t mean much, however, it becomes useful when the company’s ROE is compared with the ROE of similar companies in the sector,” he said.

“Historical comparisons can also help investors get a view as to the company’s development over time.

“The higher the ratio the better, as it means that the company is effectively deploying the capital invested by shareholders to generate profits.”


2. Debt to equity

Nieron said the debt to equity ratio is a measure of company’s financial leverage and is considered a gearing ratio.

“Gearing ratios are financial ratios that compare the owner’s equity or capital to debt or funds borrowed by the company,” he said.

“The debt to equity ratio compares a company’s total liabilities to its shareholder equity.

“It is considered one of the most important corporate valuation metrics because it highlights a company’s dependence on borrowed funds and its ability to meet those financial obligations.”

He said quality companies typically have low financial leverage and the ability to service debt due to cash on hand.

“This in turn makes them better placed to navigate macroeconomic slowdowns,” he said.


3. Earnings stability

Neiron said earnings stability is a measure of how consistently a company’s earnings have been generated over time.

He said investors should note a quote from Benjamin Graham, the father of quality investing – investors should demand from a company “a sufficiently strong financial position and the potential that its earnings will at least be maintained over the years.”

“Looking at a company’s earnings stability over time in conjunction with other metrics can enhance stock selection by eliminating stocks of companies with highly volatile, unpredictable earnings in turn reducing portfolio volatility,” Neiron said.

“To form a view as to a company’s earnings stability investors can look at dividends, the stability of cash flow earnings and sales over time.

“Capital expenditure and the ratio of investment to assets are also useful.”

Neiron said quality companies have dependable earnings and are lowly leveraged, so they are able to better withstand the extremes of the economic cycle.

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