Invest like Jeremy Grantham: 6 'quality' stocks and ETFs

At the recent Livewire Live event in Sydney, well-known global investor Jeremy Grantham singled out ‘quality’ as the factor he’s most interested in right now.

More specifically, Grantham said the following:

• "If I had to buy US stocks – and most people do – I would concentrate on quality. I am very nervous about the economy and quality protects you to some considerable degree," he said. 

• "Top-quality stocks should yield a point less (a point = 1 dollar in US stock market parlance), just like triple-A bonds yield a point less, but they do not. In real life, for the last 100 years, or 50 years, or 10 years, quality stocks have yielded an extra half a point.

• "Quality is the major aberration in the efficient market... And it’s the major inefficiency that you should take advantage of."

That’s a pretty compelling observation, backed by evidence, from one of the most successful investors in the world. 

But the question begs, what exactly does quality look like and if you’re not a stock picker, how can you get exposure?

I recently reached out to Russel Chesler from VanEck Australia to discuss how they define quality, what metrics are important in that definition, what role quality plays in a portfolio, and the products they have available for investors interested in this theme.

There are many definitions of quality when it comes to investing. How do you define it and why?

Chesler: Quality companies are typically defined as those companies that have a high return on equity, sustainable earnings and a strong balance sheet. 

Benjamin Graham who taught Warren Buffet how to invest said that when selecting a share “the investor should demand a satisfactory ratio of earnings to price, a sufficiently strong financial position and the prospect that its earnings will at least be maintained over the years”. 

Such companies have durable business models and sustainable competitive advantages and generally are better placed to withstand negative business cycles, providing a margin of safety that protects investors from poor decisions and market declines. 

The concept of “margin of safety” goes beyond simple price valuation. Careful analysis of company fundamentals such as their profitability track record, earnings stability and financial health forms the basis of the evaluation.

What research is available to support quality as a worthwhile investment style? 

Quality through the cycle

Source: ISM, MSCI, Bloomberg.

Chesler: There is extensive research that shows that quality growth stocks have historically outperformed the market with relatively low volatility over long time periods.

MSCI updated its Quality Time research paper in June 2023. The paper titled Quality Time: Understanding Factor Investing found:

“The past decade's market turbulence, marked by a bear-market episode, rising inflation and fluctuating rates, has emphasized the importance of high-quality firms. The extended history presented here offers robust evidence of quality’s performance and resilience. It also demonstrates its role in navigating risk and return in an ever-changing investment landscape.”

Why is quality investing important right now, given the prevailing economic and market conditions?

Chesler: The quality factor is a defensive strategy that has demonstrated outperformance in what is known as a ’low growth’ economic environment, and many market pundits believe we are in such an environment now. 

A case in point is the number of quality companies that are still performing strongly despite the difficult macroeconomic climate. For example, Alphabet (NASDAQ: GOOGL) remains a strong ‘buy’ with most research analysts in the US according to Barrons. Goldman Sachs recently said Alphabet remains a favourite as ad trends stabilise. The investment bank also said the company has scaled multi-year investments in AI for both consumers and enterprises beginning to be realised by investors.

Facebook parent company Meta (NYSE: META) is also an analyst favourite, Citi Vice President of Equity Research, Ronald Josey recently said, “We believe Meta is taking share of the broader online advertising market …we believe there remains upside as engagement grows The bank has a $385 price target on the stock which implies a 28% gain from its current price of around $300.”

UnitedHealth (NYSE: UNH) is another company on analysts’ radar with Morgan Stanley recently putting it on their recession-resistant list. The investment bank predicting earnings-per-share growth of about 12% annually for the next three years to about $35.71 by 2026.

All three companies have higher Return on Equity, lower debt, and superior long-term growth when compared to the MSCI world Ex Australia Index. Alphabet stands out on all three fundamental measures with a high ROE of 23.6%, low debt to equity of 11.7% and strong long-term EPS growth 

These companies are providing investors with high returns, sustainable earnings, and strong balance sheets which is the way we define quality. 

Source: MSCI, FactSet, as at 31 August 2023

What role does quality play in a portfolio? 

Chesler: Quality tends to behave defensively in downturns, by falling less and recovering faster, so it is often used as a defensive strategy. Investors may have heard the phrase “flight to quality”, which refers to the rush out of riskier assets during volatility and bear markets. 

What this means is that when risks are pronounced in markets investors choose quality versus non-quality assets to ride the storm. However, quality also tends to capture a fair share of the upside in bull runs. As a result, we believe quality is an approach for all seasons.

Quality has shown to outperform over the long term but naturally has periods of both outperformance and underperformance. These tend to correlate with the economic cycle. The table below demonstrates the returns of the quality factor through the cycle compared to other MSCI factors: 

Total performance (% per annum) during different economic regimes

Source: VanEck, Bloomberg. November 1998 to April 2023. Past performance is not a reliable indicator of future performance.

You can see from the above table that quality was among the top two returning factors in three out of the four economic regimes and second overall.

How does quality compare to other investment styles? What are the benefits, as well as the drawbacks?

Chesler: There are various factor styles that target specific fundamental attributes of companies. These include among others value, growth, size, yield, momentum and low volatility. Quality tends to have a tilt towards growth as well.

Each factor or investment style has particular performance attributes in different market conditions. For example, quality tends to outperform the general market when the economy is in the contraction and recovery stage. In this stage of the cycle, quality companies provide stability via stable earnings. In the long term quality companies provide capital appreciation as they tend to perform well over time. Quality companies can experience some underperformance when the economy is expanding rapidly and companies are leveraging their balance sheets.

Are there ETFs available to investors that offer "quality" exposure?

Chesler: We have a suite of ETFs on ASX that provide access to quality companies:

The VanEck MSCI International Quality ETF (ASX: QUAL) provides investors with a portfolio of 300 of the world’s highest-quality companies based on the principles of quality investing advocated by investment greats Benjamin Graham and Warren Buffett, namely:

• High ROE;

• Stable year-on-year earnings growth

• Low financial leverage.

The VanEck MSCI International Quality (Hedged) ETF (ASX: QHAL) is an Australian dollar hedged version of QUAL so you can now also manage your currency exposure.

The VanEck MSCI International Small Companies Quality ETF (ASX: QSML), which we affectionately call ‘Baby QUAL’, harvests the Quality factor, like our QUAL and QHAL ETFs, but selects its companies from the international small-cap universe, and as you would expect drawdowns have historically been better than its market benchmark index, the MSCI World ex Australia Small Cap index.

Outperformance in times of volatility

‘Flight to quality’ is reinforced during periods of heightened volatility. In the chart below, when the aqua line is rising, quality is outperforming. In the five most recent periods of increased volatility, quality has outperformed the market benchmark.

Relative performance of Quality vs VIX. Source: MSCI Data/Calculations, Bloomberg, 29 January 1999 to 31 August 2023.Chart shows performance of MSCI World ex Australia Quality relative to MSCI World ex Australia compared to VIX Index. Results include the reinvestment of all dividends, but exclude fees and other costs associated with an investment in QUAL. You cannot invest in an index. Past performance is not a reliable indicator of future performance of the index or QUAL.

Over 12 months to the 30th of September 2023, global small-cap companies, as measured by the MSCI World ex Australia Small Cap Index, rose 13.80%. Over the same period QSML’s index, the MSCI World ex Australia Small Cap Quality 150 Index which only includes 150 ‘quality’ global small-cap companies has risen 25.48%. However, we would always note that past performance cannot be relied upon for future performance.

Our quality ETFs have been performing strongly – historically, equities and more specifically international equity as a segment have almost always attracted the most flows. However, flows have softened this year and within the asset class, we are observing greater selectivity and pursuit for targeted exposure, which is driving a trend of diversification away from companies exhibiting unfavourable valuations or fundamentals.

Accordingly, flows into smart beta strategies, particularly those that provide exposure to the quality factor have increased. YTD net flows into international equity strategies have been a muted $768.7 million to 31 August 2023. Our three quality ETFs have combined for YTD net flows of $524.7 million, making up 68.3% of all flows into the segment. We expect this trend to continue in light of heightened inflation and rates into the end of the year. QSML in particular attracted the most flows YTD within the international small- and mid-cap segment.

This article was originally published for Livewire Markets on Friday, 6 October 2023.