Value or Growth? How About Quality

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Value or Growth? How About Quality

Many of the stocks that worked well last year are not as strong now, even though earnings have not disappointed. What's going on and what should you do?

Published by Motley Fool Wealth ManagementTue, May 18, 2021

read time 7 min read

Inflationary fears often cause investors to re-think their investment strategy. Historically this leads them to seek “safer” investments. For stocks, that has traditionally meant moving away from growth-oriented names toward value.

Most investors define growth as stocks that have the potential to grow faster than the market. Value, on the other hand, is stocks that are believed to be trading below their fundamental—or intrinsic—value.

What's this mean for your portfolio?

The debate between value and growth is heating up, forcing investors to choose one side or the other. Because while over the last decade growth investing was the place to be, more recently, value has posted stronger returns (as the chart below shows).

OutpreformedGrowthv2-1Source: S&P Capital IQ. Growth ETF is represented by the iShares Russell Top 200 Growth ETF. Value ETF is represented by the iShares Russell Top 200 Value ETF. Broad Market ETF is represented by the iShares Russell Top 200 ETF. Returns are dividend-adjusted pricing. Data from Jan. 4, 2010, through Apr. 18, 2022.

But we take a different approach altogether. We don't look at companies as value or growth. Instead, we seek Quality. Our definition of Quality seeks to identify qualitative business characteristics which we believe enable great performance across economic environments, regardless of which style is in favor.

We believe Quality companies...

  1. can raise prices.
  2. should generate positive cash flow.
  3. have customer loyalty.
  4. have the potential to maintain competitive advantages.
  5. do not rely on external sources to fuel growth.

So instead of investing based on low multiples (value) or growth expectations, we look for companies that we believe can control their destinies and deliver returns to shareholders. Historically, these companies typically perform relatively well in all economic environments. As the graph below shows, a Quality factors-based index delivered excess returns over a broad market global index in periods with rising and falling inflation between December 1975 and October 2021.1

Quality-Performs2Source: MSCI.com. MSCI World “factor” indexes are rules-based indexes (as opposed to traditional market-cap-weighted indexes) that capture the returns of systematic factors that have historically earned a persistent premium over long periods of time. A factor can be thought of as any characteristic relating to a group of securities that is important in explaining their return and risk. Factor investing is the investment process that aims to harvest the risk premiums associated with each factor. MSCI currently identifies six equity risk premia factors: Enhanced Value, Equal Weighted, Minimum Volatility, High Yield, Quality, and Momentum. Left side chart: Monthly excess returns over the MSCI World Index from December 1975 to October 2021. Right side chart: 10-year annualized performance through Apr. 8, 2022, is gross of fees.

Positive action in a negative market

Despite our unique lens focusing on Quality companies, our strategies may—and do—underperform at various points in time, which should be no different than the performance of peer portfolios. That’s because no one style is always in favor. We understand that standing back as your portfolio loses value is never easy. Sometimes you are compelled to take action. Here are three strategies that seem sensible during a market decline:

  1. Diversify. Consider adding another strategy to your asset allocation. Including an asset class or investment that is uncorrelated—moves independently of other assets—to your portfolio may reduce your total risk.
  2. Consider purchasing stocks. Depressed stock prices—especially when the fall is unrelated to the companies’ specific operations—can present opportunities to buy good companies at cheap prices.
  3. Review asset allocation. This period may shed light on your ability—or willingness—to weather market drawdowns. You may want to review your portfolio's allocation and shift towards a more conservative one if market declines are too nerve-wracking.

Easing concerns

The rotation from growth into value—or vice versa—is not uncommon.2 Despite the normalcy of shifts like this, it is still disconcerting to watch your portfolio fall.

But we feel the key is to hold companies that you believe control their destinies. These companies will not outperform all the time—no company ever will. But we believe that they can grow faster than the market and drive strong returns for investors over the long term.

While near-term volatility is hard to swallow, knowing that the market goes through bouts of volatility and tends to move higher over time—led by, in our view, Quality companies—can be comforting. In addition, recognizing that your wealth plan expects bouts of short-term volatility while driving towards your long-term goals should help ease your concerns.

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Footnotes

1 MSCI.com. MSCI World “factor” indexes are rules-based indexes (as opposed to traditional market cap weighted indexes) that capture the returns of systematic factors that have historically earned a persistent premium over long periods of time. A factor can be thought of as any characteristic relating a group of securities that is important in explaining their return and risk. Factor investing is the investment process that aims to the harvest the risk premiums associated with each factor. MSCI currently identifies six equity risk premia factors: Enhanced Value, Equal Weighted, Minimum Volatility, High Yield, Quality and Momentum.

2 Hartford Funds. Data from Jan. 1983-Mar. 2021. Created May 2021.

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