Quality counts when investing in uncertain times – and these are the reasons
Clyde Rossouw, Co-Head of Quality at Ninety One, says that in a world of disruption, investors should back quality businesses that drive change, or benefit from barriers that contribute to an enduring competitive advantage. This creates resilience in tough times and growth potential during a recovery.
The initial consensus in mid-2021 that inflation fears were transitory has shifted, given the ongoing challenges of the energy crisis and supply chain bottlenecks. In parallel, many businesses are confronted by ever-rising input costs as Central banks have embarked on what is potentially a series of interest rate hikes.
In times like these, investors can no longer simply follow the herd. This is generally well understood, as is the need to diversify portfolios. This is not a time to blindly allocate to broad indices in hope. Returns still drive allocation decisions, so how can we generate positive performance in tough market conditions?
The key is to take a highly differentiated approach to traditional benchmarks. This can help investors avoid over-reliance on a relatively limited number of well-known stocks that dominate global indices and have driven historic returns.
Looking beyond value and growth
To achieve this, companies that we define as quality – like those in our Global Franchise Fund – offer an attractive option. These companies hold long-term competitive advantages that enable them to deliver lasting structural growth and resilient earnings growth throughout market cycles, including more uncertain ones. With an ability to generate cash regardless of the macro backdrop, they can potentially outperform the wider market, with an opportunity to pay out dividends.
Quality investing differs from more familiar styles such as value or growth investing. Conventional wisdom in an inflationary environment is to back companies with growth potential due to their pricing power and capital-intensive nature. However, businesses with high fixed cost bases and the need to invest heavily, are likely to face headwinds as borrowing costs rise. They are, therefore, likely to fare far worse during inflationary periods.
Similarly, a common belief that can mislead investors, is the need to own value or cyclical stocks in periods of inflation and rising rates. This is based on expectations that holdings will benefit from lower starting valuations and shorter-dated cash flows as discount rates rise. Yet quality companies, with typically stronger balance sheets, will be less impacted by higher financing costs as rates rise – they will also actually benefit directly from higher rates where they have net cash on their balance sheet.
Quality to the core
Ninety One takes a purist approach to prevent any blurring of the definitions of growth or value investing. Our quality investment approach reflects a purer, more consistent expression of quality that is focused solely on what we view as attractively valued, best-of-breed quality companies with the same core DNA. We believe these stocks will drive long-term outperformance over a full cycle.
The timeless nature of quality is a critical differentiator for investors, and within an overall portfolio, the differentiated allocation that these companies offer can lead to a smoother journey throughout the cycle. And in times like these, three core characteristics in particular – pricing power, low capital intensity and healthy balance sheets – help insulate quality businesses from the damage inflation and rate hikes can bring, allowing them to deliver resilient earnings growth.
Our preferred companies have invested substantially to reinforce their business models, with significant exposure to key long-term trends such as data usage and digitalisation, ageing populations and healthcare, and nutrition and wellness.
These considerations result in a high conviction, low turnover portfolio, based on a philosophy of “know what you own and why you own it”. We know the companies we own because, in most cases, we have been long-term shareholders, and we strive to compound their attractive returns and dividend growth over a long-term investment cycle. But we are not blind to new opportunities and have exposure to key developing themes. In a world of disruption, investors should back businesses that are driving change, or have significant barriers to entry. Either way, a well-trodden process is needed to identify the right companies.
In a nutshell, five key attributes we seek for investments in our Global Franchise Fund are:
- Hard-to-replicate, and enduring competitive advantages
- Dominant market positions in stable, growing industries
- Low sensitivity to economic and market cycles
- Healthy balance sheets and low capital intensity
- Sustainable cash generation and effective capital allocation
Microsoft is a tangible example of a company that encompasses these attributes, with considerable pricing power. The company recently raised its subscription price of Office 365, which translates into pure profit for the company. Customers have limited ability to protest or substitute. High-quality companies are typically not economically sensitive as they sell daily-use products and services, or have recurring revenue streams with structural growth. The combination of pricing power and stable revenue creates robust earnings growth, cash flow and dividend growth.
We believe quality companies can deliver consistent long-term performance and growth irrespective of the macro picture. In times like these, the opportunity to generate real long-term growth is often the greatest. Focus on quality at a reasonable price, rather than growth at any price. DM/BM
The information contained in this article is intended primarily for journalists and should not be relied upon by private investors or any other persons to make financial decisions. All the views expressed about the markets, securities or companies in this document accurately reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Ninety One SA (Pty) Ltd in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. We do not undertake to update, modify or amend the information on a frequent basis or to advise any person if such information subsequently becomes inaccurate.
Ninety One SA (Pty) Ltd is an authorised financial services provider.
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