Quality features are an integral part of a long-term equity strategy that can surmount short-term challenges. In this roundtable, three chief investment officers of AllianceBernstein’s US equity portfolios discuss their approaches to identifying quality stocks and explain why they think quality will ultimately perform well again despite a difficult 2022.
Stocks with quality features haven’t performed well during the 2022 market downturn. Can you explain why, and why do you think quality will reassert itself in the future?
Frank Caruso, Chief Investment Officer, US Large-Cap Growth: In our view, this year’s market sell-off was quite anomalous in that it was initially driven by higher inflation and rising interest rates, rather than broader macroeconomic growth concerns. As inflationary pressures proved to be more persistent, that necessitated higher interest rates, which then put upward pressure on equity discount rates and downward pressure on valuations. These forces supported out performance of value stocks while disproportionately impacting growth stocks. Quality characteristics like balance-sheet quality and profitability were largely disregarded as investors flocked to cyclicals, and later, defensives. In the tail end of the first half, investors grew increasingly fearful of the implications of tighter monetary policy and higher rates on broader economic growth. Our belief is that as the market environment becomes increasingly challenging, quality factors—namely, growth, profitability and balance-sheet quality—will come back into vogue as investors recognize the importance of sustainable growth drivers in the absence of economic growth.
Jim Tierney, Chief Investment Officer, Concentrated US Growth: Frequently, companies that are high quality are rewarded with higher price-to-earnings (P/E) multiples. This year, multiple compression in the market is as severe as I can remember, given the Fed’s aggressiveness in raising interest rates. So, investors sold high P/E stocks without much regard to quality or earnings growth. Quality will eventually reassert itself, most likely when the Fed nears the end of its rate hikes and investors assess the economic damage caused by this policy. We believe that companies with more durable earnings prospects, frequently associated with quality characteristics, should outperform in that environment.
Why is a focus on quality important in your portfolio approach, and how do you apply quality in your stock-picking and risk management processes?
Dan Roarty, Chief Investment Officer, Sustainable Thematic Equities: We seek to own high-quality companies aligned with sustainable themes that can outperform consensus expectations over time. To us, quality is linked to the creation of economic value. Firms create economic value when they deploy incremental capital at rates of return above their cost of capital. They destroy value when their incremental returns are below their cost of capital. High-quality businesses are typically characterized by some combination of durable growth, higher profitability, lower risk (strong balance sheets, higher business stability, etc.), competent leadership and strong competitive positioning. But not all high-quality firms have the same mix of characteristics or pursue the same strategies for economic value creation. The common denominator is, however, the creation of sustainable economic value. We target high-quality companies by focusing on longer duration and less cyclical sustainable investment themes and by forecasting our valuation models out five years into the future. Further, we assess the quality characteristics mix on an individual basis, instead of having a blanket approach and targeting one or two quality factors from a quantitative perspective. The payoffs to owning higher-quality businesses accrue over longer periods of time through the power of compounding.