QD View: Unloved quality

At a time when high inflation and rising interest rates are unnerving global stock markets, it would seem like a moment for quality companies to come to the fore – writes Cherry Reynard

 
These businesses should have impeccable credentials for an uncertain world – sound business models, strong management teams, expanding market share – providing stability at a time of crisis.

Yet this has been a difficult pond in which to fish since the start of the year. A number of trusts where managers focus on companies with these quality characteristics, particularly in the small and mid cap area, have been hit hard during the recent market rout. The previously top-performing BlackRock Throgmorton and Montanaro UK Smaller Companies trusts, for example, are both fourth quartile over six months. The same phenomenon has been seen in the bond market, with Henderson Diversified Income also struggling since the start of the year.

The most obvious reason for the weakness in the quality factor is the swift and sweeping rotation from growth to value since the start of the year. In its most recent commentary, Montanaro says this dramatic style shift was “one of the fastest that we have witnessed in over 30 years of managing small and mid-cap portfolios.” This shift was prompted by an alarming spike in global inflation and well-founded fears of interest rate rises. Higher interest rates dim the relatively attractiveness of long-duration assets – most quality businesses tend to fall into that category and have been caught up in the sell-off.

Nevertheless, there are other factors at work. Dan Whitestone, manager of the BlackRock Throgmorton trust, says there has been an instinct to ‘sell what’s done well’. High quality growth companies have been the darlings of the stock market over recent years. In many cases, they have shaken off – or actively benefited from – the disruption created by the pandemic. Valuations, in some cases, were priced for perfection.

A final problem, particularly at the smaller company end, is that any mistakes have been dealt with savagely by investors. In under-researched and less liquid shares, short-term weakness can prompt significant falls in share prices. Throgmorton, for example, held S4 Capital and Avon Protection[1], both of which experienced problems. The manager moved quickly to reduce the positions, but inevitably, it has weighed on performance. For Montanaro, NCAB and Vitrolife have been weak spots.

The experience of Henderson Diversified Income, which is focused on quality debt rather than quality equities, has been similar. Over six months, its NAV is off by 13.1% and its share by 12.7%.

The equity funds have found that their share prices have fared worse than their NAVs. For Montanaro UK Smaller Companies, for example, the share price has dropped 34% over six months (source, Trustnet, to 20 May 2022), compared to a drop of 27.3% in its NAV. For Throgmorton, a 33.5% decline in the NAV has been accompanied by a 41% drop in the share price.
 

The merits of the growth approach

 
For investors, the question is whether these falls represent an opportunity. John Pattullo, who takes a quality-focused approach for his bond portfolio on Henderson Diversified Income trust, is clear that this philosophy has merit over the long-term: “The problem with a ‘value’ approach for bonds is that a security is probably cheap for a reason. Money doesn’t grow on trees and markets aren’t that inefficient,” he says.

He says: “Some industries get too much capital and don’t do a good job with it.” Pattullo points to research from Aswath Damodaran from NYU’s Stern Business School that shows certain industries are inherently bad at generating a return on capital higher than their cost of capital – including banks, shipping, autos and airlines. Investors may be able to hold them at a certain point in the cycle, but over the long-term, these areas destroy value. He adds that ESG concerns also need to be considered. If a business is to be genuinely sustainable, it needs to look after all its stakeholders and the environment.

Pattullo says avoiding these value destructive industries may exclude a fair chunk of the market – for bonds, it is around one third of both the high yield and investment grade markets. Nevertheless, it should leave investors with industries that are growing in the long term: “The quality filter works well over time, but cannot possibly protect against short-term shifts in markets,” he says.
 

The advantage of quality today

 
The managers of both the BlackRock and Montanaro trusts are clear that many of the companies within their portfolios are still performing well operationally. For them, this is a transitory setback and not reflective of the long-term growth potential of many of their companies.

Pattullo says the pandemic has accelerated structural trends, which in turn will exacerbate the gap between winners and losers. Stronger players are likely to see outsized market share gains. Pricing power matters, of course, at a time of inflation, but equally important – at a time when supply chains are under threat – is the availability of stock. This is a key advantage for well-run, higher quality businesses.

At the same time, the ‘zombie’ companies could be in real trouble. These are companies with high debt that can just about pay the interest on their loans and not much else. They have been kept alive by low interest rates and government support, but can’t invest to build future growth. If rates rise, paying the interest on their debts may prove increasingly difficult.

In its most recent ‘Factor Views’ analysis[2], JP Morgan sees an opportunity in the quality segment: “The quality factor now appears particularly interesting – especially since it may fare well across a range of scenarios. First, the factor is nearly as cheap relative to its own history as value… Second, should the current inflationary regime continue for longer than was anticipated last year, the more profitable companies that the quality factor favours may be better positioned to pass on cost increases to consumers than are lower quality companies. Third, the quality factor is typically less challenged than value in scenarios of slowing economic growth and tends to fare better in late-cycle environments.”

The premise of quality investing is that earnings power determines success. Over time, it is outcomes for individual companies and sectors that drives returns. Today, quality-focused managers believe a changing environment, with higher inflation and rising interest rates, could have serious ramifications for companies without key quality characteristics, such as pricing power, strong supplier relationships, capable management and a growing end market. If investors agree, this could be a moment to re-examine this part of the market.
 
[1] https://www.blackrock.com/uk/solutions/investment-trusts/our-range/blackrock-throgmorton-investment-trust/trust-information?cid=ppc%3Ainvestment-trusts_uk%3Agoogle%3Abrand%3Aen&gclsrc=aw.ds&gclid=Cj0KCQjwhLKUBhDiARIsAMaTLnFqBNLlcawoLjKhikkjeexF4E2TBAVKbMB68t3KIQ7i_C8cswqft7oaAiMcEALw_wcB#fund-manager-commentary