QD View – Unloved Quality

At a time when high inflation and rising interest rates are troubling global equity markets, it seems like the time has come for quality companies to take center stage. These companies must have impeccable credentials for an uncertain world – strong business models, strong management teams, expanding market shares – providing stability in times of crisis.

However, it has been a difficult pond to fish since the beginning of the year. A number of trusts where managers focus on companies with these quality characteristics, particularly in the small and mid cap space, have been hit hard in the recent market rout. For example, BlackRock Trusts Throgmorton and Montanaro UK Smaller Companies, previously the best performers, are both in the fourth quartile over six months. The same phenomenon has been observed 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 rapid and drastic rotation from growth to value since the start of the year. In his most recent commentary, Montanaro says this dramatic change in style was “one of the fastest we’ve seen 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 rising interest rates. Higher interest rates dampen the relative attractiveness of long-lived assets – most quality companies tend to fall into this category and have been caught in the sale.

However, other factors come into play. Dan Whitestone, director of the BlackRock Throgmorton Trust, says there has been an instinct to “sell what’s done right”. High-quality growth companies have been the darlings of the stock market in recent years. In many cases, they shrugged off – or actively benefited from – the disruptions created by the pandemic. The evaluations, in some cases, aimed for perfection.

A final problem, especially on the small business side, is that any mistakes have been dealt with roughly by investors. In under-researched and less liquid stocks, short-term weakness can lead to significant declines in stock prices. Throgmorton, for example, owned S4 Capital and Avon Protection[1], both of which ran into trouble. The manager acted quickly to reduce positions, but inevitably this weighed on performance. For Montanaro, NCAB and Vitrolife have been weak points.

The experience of Henderson Diversified Income, which focuses on quality debt rather than quality stocks, has been similar. For six months his NAV fell by 13.1% and its share by 12.7%.

Equity funds found that their stock price fared worse than their net asset value. For Montanaro UK Smaller Companies, for example, the share price fell 34% over six months (source, Trustnet, as of May 20, 2022), against a 27.3% drop in its NAV. For Throgmorton, a 33.5% drop in net asset value was accompanied by a 41% drop in 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-driven approach to his link wallet on Henderson Diversified Income Trust, is clear that this philosophy has long-term merit: “The problem with a ‘value’ approach to obligations is that a title 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 of it.” Pattullo points to research by Aswath Damodaran of NYU’s Stern Business School that shows some industries are inherently bad at generating a return on capital greater than their cost of capital – including banking, shipping, automotive and Airlines companies. Investors may be able to hold them at some point in the cycle, but in the long run these areas destroy value. He adds that ESG concerns must also be taken into account. If a company wants to be truly sustainable, it must take care of all its stakeholders and the environment.

Pattullo says avoiding these value-destroying industries can shut out a good chunk of the market — for bonds, that’s about a third of high-yield, investment-grade markets. Still, that should leave investors with long-term growth industries: “The quality filter works well over time, but in no way can protect against short-term changes in markets,” he says.

The quality advantage today

The managers of the BlackRock and Montanaro trusts are clear that many of the companies in their portfolios are still doing well operationally. For them, this is a transitory setback that does not reflect the long-term growth potential of many of their businesses.

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, in times of inflation, but just as important – in times when supply chains are under threat – is inventory availability. This is a key advantage for well-run, higher-quality businesses.

At the same time, “zombie” companies could be in big trouble. These are heavily indebted companies that can barely pay the interest on their loans and not much else. They have been kept alive by low interest rates and government support, but cannot invest to build future growth. If rates rise, paying the interest on their debts may become increasingly difficult.

In his latest analysis “Factor Views”[2], JP Morgan sees an opportunity in the quality segment: “The quality factor now appears particularly attractive – especially since it can perform well in a range of scenarios. First, the factor is almost as cheap relative to its own history as the value… Second, if the current inflationary regime were to continue longer than expected last year, the most profitable companies that the quality factor favors could be better placed to pass on cost increases. to consumers than lesser quality companies. Third, the quality factor is generally less contested than value in slower economic growth scenarios and tends to fare better in late cycle environments.

The premise of quality investing is that beneficiary power determines success. Over time, it is the results of individual companies and sectors that drive returns. Today, quality-focused managers believe that a changing environment, with higher inflation and rising interest rates, could have serious ramifications for companies without key quality characteristics, such as power. pricing, strong supplier relationships, competent management and a growing end market. If investors agree, it might be time 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

[2] https://am.jpmorgan.com/gb/en/asset-management/adv/insights/portfolio-insights/asset-class-views/factor-views/

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