After a major rally that pushed major stock indexes to new highs, some investors only want the good things.
After a major rally that pushed major stock indexes to new highs, some investors only want the good things.
They look for high-quality stocks, which are broadly defined as stocks of companies that have a combination of growth, reliable earnings and strong balance sheets. They run the gamut from recent standouts like Microsoft and Nvidia to established performers like Coca-Cola and Johnson & Johnson.
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They look for high-quality stocks, which are broadly defined as stocks of companies that have a combination of growth, reliable earnings and strong balance sheets. They run the gamut from recent standouts like Microsoft and Nvidia to established performers like Coca-Cola and Johnson & Johnson.
Banks, including Goldman Sachs, UBS and Wells Fargo, recommended investors buy high-quality stocks in their forecasts for next year. GMO, the asset management firm co-founded by Jeremy Grantham, launched a quality-focused actively managed exchange-traded fund, the firm’s first ETF, in November.
One big reason they care: High-quality companies tend to do better than others when growth slows — the environment most Wall Street expects this year — isolated by their flat financial results, low debt, large cash holdings, or other strong business fundamentals. . . The MSCI ACWI Quality Index has historically outperformed the MSCI World Index by 1 percentage point during six-month periods when the economy slowed but continued to expand, according to UBS analysts.
This reliability tends to make high-quality stocks relatively expensive, meaning investors may miss out on some gains in a big rally. But for those who worry that recent increases in stocks and bonds won’t last after a tough start to the year, seeking quality offers a way to stay invested while potentially cushioning some of the blow if markets turn around. The S&P 500 rose 0.3% to start 2024.
In the coming days, investors will analyze earnings reports from companies like Goldman, shipping company JB Hunt Transport Services, and oilfield services company SLB as they try to gauge the strength of the economy. Markets are closed on Monday for Martin Luther King Jr. Day.
Gerald Goldberg, CEO of investment advisory firm GYL Financial Synergies, said his firm adjusted its model portfolios in 2022 to increase exposure to quality companies. A year later, the move paid off.
“Our theory has historically been that when the economy slows or goes into contraction, higher quality companies will have higher credit ratings and stronger balance sheets. Wider moats around their businesses tend to perform better on a relative basis,” he said. Compared to those of lower quality.”
The iShares MSCI USA Quality Factor ETF rose 29% in 2023, according to FactSet, ahead of the S&P 500’s 24% rise. It lagged the index’s 19% decline in 2022, falling 22%.
Some research shows that high-quality stocks provide better returns after accounting for risk. A 2013 paper by AQR Capital Management’s Cliff Asness, Andrea Frazzini and Lasse Pedersen found that despite high costs, there are “strong and consistent abnormal returns to quality,” and that a strategy of betting on high-quality stocks and against stocks of weaker companies will achieve Great returns in the US and elsewhere.
Allen T says: Bond, head of research at Jensen, says high-quality companies create value through sustainable competitive advantages, growth and financial strength. He also looks for flexibility, such as free cash flow generation and opportunities to invest in new initiatives.
“We are not always looking for explosive growth when we focus on high-quality businesses, but we want attractive long-term growth, and what is most important to us is growth that we believe is predictable,” he said.
More recently, these companies have included some of the Big 7 tech companies — Alphabet, Amazon.com, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla — that contributed to much of last year’s stock market rally. Many of these numbers are among the largest holdings in the iShares ETF.
Some fear this is a sign that investors are chasing performance, not selecting high-quality companies. Bond warns that maintaining an inclination toward quality requires a methodical approach and commitment even when it is not in your best interest.
Others caution that what makes something quality can be difficult to understand. Morningstar analyst Ben Johnson wrote in 2019 that quality “may be the most ambiguous factor you’ll find in the investing world,” and investors may best use it to enhance their broader portfolio, perhaps through funds that include multiple investment factors.
“Price matters, perhaps more than anything else,” he wrote.
Michael Reynolds, vice president of investment strategy at Glenmede, says his company has moved toward quality. He added that despite economists’ optimistic expectations about US growth, recession fears remain high.
“We look at the last five or six markets, and quality has outperformed as a factor, and high-quality stocks tend to be strong performers in periods of market stress around recessions,” he said.
Write to Brenda Leon at brenda.leon@wsj.com