Quality missed a downbeat in 2022 for the first time in 20 years.
The investment style, based on the premise that well-made companies will consistently deliver financial returns, had outperformed the broader global equities index during the five previous calendar year market slumps recorded over the past two decades.
Amid a deep market sell-off that saw the MSCI World index fall about 18 per cent, the quality benchmark sank a further 4 per cent or so.
But 2022 was different, according to Morgan Stanley Investment Management, as company earnings and margins held up despite sharp valuation ‘de-rating’.
In a recent presentation to NZ investors with local partner Salt Funds Management, Morgan Stanley portfolio specialists noted the market de-rating of last year has “reduced but not removed valuation risk” with price-earnings multiples still higher than the long-term average.
However, while stock valuations may fall further, Morgan Stanley says the “main risk is earnings which remain elevated on peak margins”.
If earnings do disappoint, which is the Morgan Stanley base case, quality should shine again as per the example of the global financial crisis (GFC).
In fact, the presentation highlights a parallel between current conditions and the early days of the GFC when earnings peaked eight months after the start of the stock market drawdown.
From about August 2008 the earnings shoe began to drop, plunging rapidly downwards – along with valuations – through to February the next year.
And quality significantly outperformed when the earnings downtrend hit, the Morgan Stanley data shows, as companies with resilient business models and pricing power rode through the hard times.
Earnings per share have fallen on average by 17 per cent during “recessionary bear markets” over the last 150 years, with the worst decline of -73 per cent in 1929 followed by the -50 per cent crash of the GFC period.
“It is easier to compound wealth if you don’t lose as much of your initial invested capital in downturns,” the Morgan Stanley presentation notes.
Greg McMaster, Salt head of client partnerships, said the Morgan Stanley quality strategy has captured about 95 per cent of the upside and only 84 per cent of market downsides since 2014.
McMaster said a longer-running version of the portfolio – Salt uses a newer low-carbon iteration of the Morgan Stanley fund in its Sustainable Global Shares Fund – captured 88 per cent of upside and just 55 per cent of the downside.
He said as earnings come under pressure, the quality factor should come to the fore.
“When earnings are running away, you don’t expect quality to outperform,” McMaster said. “Quality does perform better when earnings are falling but managers still need to have a strong valuation discipline.”
The Morgan Stanley portfolio underpinning the Salt fund currently holds 41 stocks – the highest number for some time following some bargain-shopping last year – with a recent rotation to the “growthier” stocks in its investment universe.
Typically, the strategy allocates to four sub-sectors: software and IT services; healthcare; consumer staples; and, other niche areas such as “proprietary information providers” and media.
Morgan Stanley defines quality companies across four metrics including high returns on operating capital employed, long-term sustainability of revenue, management commitment to sustaining returns, and valuation.
Quality might be an elusive quality but McMaster said the impact of selecting companies that invest into retaining an “intangible competitive advantage” is real enough.
The 10-year margin stability of the Morgan Stanley portfolio of almost 86 per cent compared to just over 74 per cent for the MSCI World.