Look who’s making a comeback: Quality vs value investing

Investment strategies can be aligned with specific factors such as value, quality, momentum, low volatility, alpha, or a combination of these. Value and quality are often viewed as opposing strategies, as they target different characteristics of a company. Value investing seeks stocks that are trading below their intrinsic value, offering the potential for price recovery. On the other hand, quality investing focuses on companies with strong financial fundamentals.

Consequently, while value investing is centred around identifying price inefficiencies, Quality investing emphasizes the long-term stability and strength of a business, often leading to different company selections in each approach.

The value investing approach centres on finding stocks that the market has undervalued. Value investors look for companies whose stock prices are below their intrinsic or fair value, often due to temporary challenges, broader market trends, or factors that fail to capture the company's long-term potential.

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Metrics to note

Common valuation metrics such as low price-to-earnings (P/E), price-to-book (P/B), price-to-sales (P/S), and high dividend yield ratios help assess the degree of undervaluation. This strategy demands patience, as it can take time for the market to fully recognize and reflect these companies' true value.

On the other hand, businesses associated with the quality theme typically demonstrate strong fundamentals such as high return on equity (RoE), return on capital employed (RoCE), manageable financial leverage (debt/equity ratio), healthy free cash flow (FCF), the ability to generate superior returns on incremental capital, and good corporate governance. These companies also often possess sustainable competitive advantages, leading to long-term stability, more predictable returns, less volatility, strong management, and sustainable growth.

Investing in quality stocks also provides a cushion during economic downturns. Quality companies usually have solid balance sheets with lower debt, ample liquidity, and resilient business models that allow them to withstand market disruptions. These firms are often leaders in their industries, with a proven track record of navigating challenges and emerging stronger. Their consistent performance over time allows for compounding returns, making them ideal for long-term investors seeking both wealth preservation and growth. As a result, quality investments offer a more defensive yet rewarding approach to wealth creation, especially in uncertain market conditions.

Also Read: Can passive investing shield investors from market downturns?

None guarantees consistent returns

It is widely believed that focusing on a particular factor can lead to strong performance over time. Concentrated bets are often associated with high conviction, believed to enhance performance. However, this may not always hold true. Investors must remember that “winners rotate”. The best-performing market segment today may not excel in the future, and vice versa. No single style consistently outperforms every year. For example, the value style underperformed from 2018 to 2020 before making a comeback in 2021. Similarly, the quality style has had a mixed performance in recent years.

Historically, it has been observed that quality stocks perform relatively well during uncertain times. For example, the Nifty 200 Quality 30 Index performed relatively well during years like 2011, 2013, 2015, 2018, 2019, and 2020. Notably, all of these years were marked by heightened uncertainty.

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Since the beginning of 2021, value stocks have performed relatively well. However, what's interesting is that while the value theme did well in the first four months of 2024, the quality theme took over starting in May 2024. The last four months have once again been characterized by heightened uncertainty—initially related to the general elections, followed by concerns around the Union Budget, Yen carry trade issues, US economic slowdown, geopolitical tensions, and more recently, worries about foreign institutional investors reallocating money from countries like India to China.

It is important to note that while the annual performances of the Nifty 200 Quality 30 TRI and the Nifty 200 Value 30 TRI differ significantly since inception, they have generated healthy returns of 19.4% and 17.5% compound annual growth rates, respectively.

It is important for investors to remind themselves that "winners rotate". Today’s best-performing market segment may or may not perform well in the future, and vice versa. The broader equity market is an amalgamation of various factors.

Also Read: Factor investing: Unlocking market secrets with value, momentum, and quality

Therefore, when creating an equity portfolio, it is essential for investors to either choose a factor-diversified portfolio or diversify their equity investments across various schemes with different styles and factor tilts to ultimately create a factor-diversified portfolio. This approach should help improve the investing experience over time. For investors looking to make tactical calls on themes, as we say in football, "position yourself in the space where the ball will be, rather than chasing where it just was".

Manuj Jain is a CFA and director-head of products at White Oak Capital.