What You Need to Know
High-quality companies are always in style. In good times and bad, features that define resilient businesses and stocks underpin consistent and solid equity return potential. But to consistently find companies that meet the highest quality standards requires research, judgment and investing skill. In this paper, we identify the characteristics that can help guide investors to high-quality businesses, and present different investment approaches designed to capture these companies in equity portfolios.
The hunt for quality allows investors to tap equity return potential with smoother return patterns. Quality stocks with the right attributes tend to offer superior risk-adjusted returns, posting solid gains in rising markets and cushioning investors in a downturn. Over time, stocks with these all-weather characteristics have helped protect capital during events as varied as the bursting of the technology bubble, the global financial crisis and the coronavirus pandemic (Display).
For nearly 35 years, the MSCI Quality Index has delivered an annualized return of 11.1%, outperforming the broader MSCI World benchmark by 3.8% a year (Display). But to position properly in crisis periods, quality control is crucial. Investors who concentrate on quality in their everyday stock-picking processes are better equipped to identify durable companies that have what it takes to get through uncertain times and to thrive in a recovery.
What Distinguishes True Quality?
Capturing the superior risk-adjusted returns that quality stocks offer requires a forward-looking approach and identifying the right measures to pursue. We believe that sturdy balance sheets, high and stable profits and strong free cash flows are good ways to identify companies with the ability to perform well through changing market conditions.
Passive approaches use various measures to define quality, but they’re backward looking. This presents a severe flaw in systemic crises, particularly the COVID-19 pandemic, in which the future will look nothing like the past. For example, some companies that scored high on quality measures such as earnings growth and profitability in the past faced pressure in the coronavirus recession, as rampant demand destruction unfolded in unpredictable ways.
Three Interconnected Features
To find quality today, investors need a discerning view of a company’s underlying dynamics. By studying industry conditions, demand drivers and company business models, investors can assess quality using these three lenses:
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High and Stable Profitability—This is usually a sign that a company has a differentiated and durable business that can do well through changing macroeconomic cycles.
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Strong Free Cash Flow—Good businesses generate excess cash, the lifeblood of economic activity. This gives companies more financial flexibility to enhance shareholder returns.
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Healthy Balance Sheets—Companies with ample cash and low debt levels have a healthier foundation to invest for the future and execute strategy without being subject to the moods of capital markets.
The three characteristics above are interconnected. Companies that generate consistent free cash flows are in a better position to cover debt-servicing costs—even when there’s less cash to keep the business afloat. And low earnings volatility is a good indicator of a company’s ability to perform through complex and changing business conditions.
Past performance, historical and current analyses, and expectations do not guarantee future results. There can be no assurance that any investment objectives will be achieved. The information contained here reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed here may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AB or its affiliates.
The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.
© AllianceBernstein
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