2021’s Winner and What It Could Mean for Long-Term Investing

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2021’s Winner and What It Could Mean for Long-Term Investing

After years of being one and the same, in 2021, many investors had to make a choice between growth and quality. Who won… and why?  

Published by Motley Fool Wealth ManagementWed, Jan 26, 2022

read time 4 min read

Since the early 2000s, high-growth and quality stocks often seemed like one and the same. What kinds of companies did this pairing represent? Ones that we use every day—like Amazon, Apple, Microsoft, Facebook, and Google#, among many others. So while these technology companies delivered high-flying growth, they also created and frequently led new markets, had pricing power, and moved from luxuries to necessities—the exact definition of quality.

Their dominance was pronounced through the bull market that followed the 2008 Global Financial Crisis. And because bull markets tend to have a “rising tide lifts all boats” atmosphere, other technology companies rode their coattails. But many of these other businesses did not represent quality—because they failed to operate profitably, did not have strong management teams, and lacked robust competitive dynamics. Yet they did exhibit high growth!

 email-chart-quality_stocks

Source: Credit Suisse HOLT. The chart shows performance correlation over time among large-cap stocks in the Russell 1000 universe associated with either growth or quality characteristics. 

So what happened in 2021? The performance separated, and many investors had to make a choice—growth or quality—but not both. The result? Growth pulled ahead of quality.

In early 2021, some of the biggest gainers were growth companies with no earnings power.1 These included many unprofitable tech companies, as well as energy companies.

email-chart-nonprofitable_tech

Source: Bloomberg. The Goldman Sachs Non-Profitable Technology Index consists of non-profitable U.S. listed companies in innovative industries. Technology is defined broadly to include new economy companies across GICS industry groupings. The basket is optimized for liquidity with no company initially weighted greater than 4.65%.

But we liken investing to the Indianapolis 500. And 2021 was just one lap in the race.

Companies with short-term growth—especially those propelled by a single factor, like the reopening of the economy, or who purchased growth through the use of cheap debt—without an underlying profitable business will probably hit the skids over the long term. But sustainable growth businesses should thrive. And that can be the difference between pulling ahead for a lap and winning the race.

Some “quality” investors only look at return on equity (ROE), earnings growth rate, or margins at a single point in time. But to better analyze future growth, other factors—like how a company is positioning itself versus the competition or if their product or service represents a shift in consumer behavior—also need to be considered.

Unfortunately, this style of investing doesn’t get rewarded immediately. It can take a while to play out and requires a long-term focus.

That’s because high-quality companies don’t lap others all the time, especially as bottlenecks, short-term disruptions, or near-term macroeconomic forces are thrown in their path. But they have the potential to maneuver around these roadblocks and speed ahead over the long haul. In that way, the truly high-quality companies often leave the competition in the dust when the race flag switches from yellow back to green.

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