Originally published at: https://blog.investengine.com/a-core-equity-allocation-for-uncertain-times-and-beyond/
2023 is shaping out to be another eventful year for investors. We have already gone through three distinct market regimes from a growth-driven rebound in January, a reversal led by very hawkish comments from the chairman of the Federal Reserve in mid-February and a risk-off movement following bank collapses in March. In such an uncertain and highly volatile environment, investing in resilient, all-weather portfolios could be key to growing wealth over the long term.
Reliable outperformance with quality-focused investment
Warren Buffet once said, “A great business at a fair price is superior to a fair business at a great price.” While a disciple of one of the most notable value investors, Jeremy Grantham, Buffet attributes most of his success to high-quality businesses that grow dividends. At WisdomTree, we also believe that holding quality dividend-growing companies can lend strength to a core strategic equity allocation. Quality investing is a strategy that has been endorsed by both academics as well as industry practitioners. Since the turn of the millennium, global quality stocks have outperformed the market by an annualised rate of 1.4%.
Figure 1: High-quality stocks historically outperformed the market with less volatility
Source: Kenneth French data library. Data is calculated at a monthly frequency and as of Nov 2022. Stocks are selected to be above the median market cap, with ‘High Quality’ representing the top 30% by operating profitability and ‘Low Quality’ representing the bottom 30% by operating profitability. The portfolios are rebalanced yearly at the end of June. The market represents the portfolio of all available publicly listed stocks in the developed world. All returns are in USD. Operating profitability for year t is annual revenues minus cost of goods sold, interest expense, and selling, general, and administrative expenses divided by book equity for the last fiscal year end in t-1. You cannot invest directly in an index. Historical performance is not an indication of future performance and any investments may go down in value.
Historically, quality stocks have exhibited higher long-term returns and lower volatility, which creates a very attractive risk-return profile for core holdings in investors’ portfolios.
Quality Investing – what is it and what makes it a resilient all-weather strategy?
While not the only strategy to have outperformed the market, Quality focused investment strategies stand out by their capacity to outperform the market across the business cycle and to capture the upside while being defensive in crises.
Quality companies tend to be very profitable; they benefit from strong business models and steady financial results over time and do not tend to rely on leverage and debt. Their financial performance is, therefore, likely to be more consistent and predictable from one period to the next. When building investment strategies focused on quality stocks, this translates into steady, robust returns in a large array of market scenarios.
Quantitatively, this versatility of Quality investing can be observed through their upside and downside capture ratios. The upside capture ratio is the percentage of market gain captured by a strategy when markets go up, and the downside capture ratio is similarly the percentage of market losses endured by a strategy when markets go down. Quality benefits from having a very asymmetric profile with an upside capture ratio of 95% and a downside capture ratio of only 87%1.
The asymmetric risk profile of quality stocks, i.e. their all-weatherness, explains both their long-term outperformance and their capacity to outperform across different market regimes and in high uncertainty.
Using quality stocks to lower drawdowns in crisis
High-quality companies tend to behave defensively in market drawdowns. When volatility and uncertainty increase, investors tend to move their equity investment toward less risky companies, usually profitable, low-debt, large-cap, household names. This “Flight to Quality” creates a tailwind for quality strategies during crises that helps those strategies outperform during drawdowns.
Looking at the last 60 years, we can see that in 12 out of the 15 worst months in US equities, a quality-focused strategy would have cushioned the drop and lowered the drawdown. In April 2022, for example, US equities lost -9.45% when a quality strategy lost only -7.73%, an improvement of 1.72%. Or in March 2020, US equities lost -13.26% when a quality strategy lost only -10.62%, an improvement of 2.64%.
Figure 2: Performance of the US High-Quality Companies in the worst 15 months for US Equities since 1963
Source: Kenneth French data library. Data is at a monthly frequency and as of 31st December 2022. Stocks are selected as above the median market cap, with quality representing the top 30% by operating profitability. The market represents the portfolio of all available publicly listed stocks in the US. All returns are in USD. Operating profitability for year t is annual revenues minus cost of goods sold, interest expense, and selling, general, and administrative expenses divided by book equity for the last fiscal year end in t-1. You cannot invest directly in an index. Historical performance is not an indication of future performance and any investments may go down in value.
This is also the case over longer time periods. During the Covid Crisis (i.e. between February and March 2020), the MSCI world lost -34% when Quality lost -30.2% cushioning the blow by 3.8%. In 2008, Quality reduced the drawdown by 5.9%2, and in 2022, it reduced it by 4.27%2.
Quality stocks tend to deliver outperformance in most crises, providing well-needed respite to investors when they need it the most. However, contrary to other defensive factors, they can also participate in the upside, making them an ideal candidate for long-term investments.
High-quality companies at a reasonable price
One of the main pitfalls of quality investing, of course, is valuation. Everyone loves profitable companies. What is there not to love? And, therefore, many of those companies can be expensive or overvalued. In financial terms, it would push a quality-focused portfolio toward growth more than value meaning investors would pay a premium for expected future growth.
As discussed earlier, the holy grail really is a “great business at a fair price” which translates into a preference for quality value companies over quality growth companies. This is why long-term, core equity strategies tend to combine high-quality metrics with a focus on valuation.
Companies with the capacity to grow their dividend in the future tend to exhibit strong quality metrics (to be able to increase their dividends) appearing more often in Value indices than Growth Indices.
How to find high-quality dividend growing companies for your portfolio
Not everyone can emulate Warren Buffett, dedicating their life to knowing every detail about every business and investing in only a few of them every decade. Instead of picking just a handful of stocks, it’s possible to create a broad rules-based, diversified basket that shares the same principles. So how do we go about finding high-quality, dividend-growing companies suited to a core equity allocation?
- When it comes to defining high-quality companies, WisdomTree tends to focus on profitability metrics. This means companies with a high return on equity (ROE) or high profits (income) over book value (and invested capital) in the business, as well as a high return on assets (ROA) to penalize leverage from driving high ROE in underlying businesses.
- Dividend-growing companies are companies that will grow their dividend in the future. This is quite different from companies that have grown their dividend in the past. At the end of the day, looking for companies to grow their dividends, is not about looking back; it is about looking forward to profitable companies that can grow earnings i.e. companies with stronger expected earnings growth relative to the market.
Combining profitability metrics and high-earning growth can help arrive at a forward-looking dividend growth basket. Selecting only dividend payers and overweighting companies that pay more dividend dollars to their shareholders can also help to keep the portfolio valuation in check by avoiding the most expensive growth-orientated stocks.
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