Why quality investing outshines value over the long term

Investing with a focus on the quality factor involves identifying companies that demonstrate strong financial health, sustainable competitive advantages, and consistent earnings growth. Quality and value are two of the oldest and most widely recognised factors in investing. The quality factor, in particular, has historically performed well in the Indian stock market, benefiting from the country's unique economic conditions and market structure.

Here's why quality as a factor tends to deliver reasonable returns:

Resilience during volatility

India’s stock market often experiences higher volatility compared to developed markets. Quality companies with strong balance sheets tend to outperform during periods of volatility; for example, during the covid period in Q1 of 2020, sectors such as healthcare, IT and FMCG, known for quality companies, handsomely outperformed the market, and the alpha in the three-month period was in the 5-20% range. The volatility of these sectors was also much lower than that of the market.

Long-term consistent growth over speculation

Quality stocks with strong fundamentals provide stability and consistently compounding returns over the long term. During speculative stages in the market, different sectors attract market attention for their potential. However, only a handful of companies can deliver, making investors return to quality. The infrastructure sector in 2007, PSUs in 2014, and NBFCs in 2018 were all followed by prolonged periods of heartburn. Quality companies almost always deliver reasonable returns after these irrationally exuberant phases.

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Sustainability, leadership and valuation premium

Many quality companies in India operate in sectors with high barriers to entry, such as FMCG, IT, healthcare or banking. These companies often enjoy a dominant market position, leading to sustained profitability and delivering reasonable returns over long period of time. They also command premium valuations to the market. However quality investing comes with its risks that investors should consider before investing.

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Valuation risk

Quality stocks often trade at premium valuations because of their strong fundamentals, profitability, and resilience. However, paying too high a price can reduce future return potential, especially if growth expectations are not met. For example, private banks which were trading at lofty valuations a few years back have had a rough time for the last couple of years.

Underperformance in momentum-driven markets

During bull market periods, momentum investing can lead to speculative, lower-quality stocks, especially in cyclical sectors like real estate, infrastructure, or small caps, outperform in short bursts. In such phases, quality stocks might lag in price performance because of their conservative growth outlook and valuation approaches.

Sectoral concentration

Focussing on quality as a factor often leads investors towards sectors, such as FMCG, IT, healthcare and banking, where companies are more likely to display high profitability, low debt, and strong balance sheets. This concentration exposes investors to sector-specific risks, such as regulatory changes, currency fluctuations (affecting IT and healthcare), or macroeconomic trends that could affect demand (like in FMCG and banking).

Overemphasis on stability at the cost of growth

Quality companies are often mature businesses with stable earnings, but they may not offer the same growth potential as smaller, more aggressive companies. This focus on stability can result in relatively modest returns during growth phases of the economy. Also, since quality often considers historical metrics, past performance may not be repeated in the future.

In the Indian markets, quality as an investment factor has outperformed over longer periods. Over the last three years, however, value stocks have taken the lead due to a surge in various businesses, with many investors overlooking quality. Nevertheless, we anticipate this anomaly will correct as investors become aware of frothy valuations and begin to seek out genuine businesses with long term history of performance.

Approaching quality as an investment factor with the right framework—avoiding questionable credentials, being mindful of growth prospects, not overpaying, and considering sector rotation within quality—can provide a source of long-term alpha with significantly lower volatility than the market.

(Vineet Sachdeva is entrepreneur partner-quantitative equity investing, Alpha Alternatives)

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