Quality of company and diversification 'even more important' amid high interest rates

As markets adjust to a new plateau of higher interest rates and bond yields, different companies are set to prosper. KBI Global Investors believes that in the new environment, speculative approaches to valuations will suffer, and that the quality of a company will be even more important, with fundamentals and tangible cashflows becoming key drivers of returns again.

It is, they believe, an environment which requires managers to adopt a far more diversified approach, which the Dublin-headquartered investment boutique sets out in a research paper, prepared by the Global Equities team, entitled 'What is Quality?'.

"Quality is a key component of our investment approach. For example, cash rich businesses with high margins, little debt and consistently growing dividends are ideal candidates for our strategy. However, on an ex-post basis, most quality metrics have underperformed for an extended period now.

"The unprecedented macro environment of QE, free money and negative yields which began in 2017 drove risk appetites to all-time highs. The ensuing preference for speculation over fundamentals led to the consistent outperformance from two types of stocks - long duration and zombie companies.

"Since late 2021 the monetary and yield environment has begun reverting back to long term norms, but quality metrics have been slow to respond when measured on a factor basis. This prompted the proprietary factor-based analysis in this research paper.

"We look at the performance and correlation of sixteen quality metrics from our factor library. We categorise them into four groups that reflect the key elements of a quality business.

• Strong balance sheet

• Good capital management

• High profitability

• Low volatility

"We measure the behaviour of these metrics through different market environments. We break the analysis down into market periods of:

• Downturn

• Slowdown

• Recovery

• Expansion

"We look across the different geographic regions of both Developed and Emerging markets. While in broad terms the basic performance rule of thumb that investors expect from quality - down markets good/up markets bad - holds true, much depends on the specific types of quality being pursued.

"For example, two metrics that most quality oriented investors would look for - strong cashflows and high return on equity."

The payoff is very different to each other and have very little performance correlation. A similar observation can be made for low accruals and high gross margins.

There are two key takeaways:

1. Investors can benefit from these differing performance and correlation profiles but a diversified exposure to a variety of quality characteristics is required.

2. Downturns and slowdowns are when quality performs best. With more volatile and less bullish markets expected, this reinforces the need for quality despite the performance costs in recent years.

In its conclusion, KBI Global Investors argues that diversification is vital within quality exposure.

"Quality is an important but often contested investment style. While it's intuitively good to have, it can seem difficult to define. To help untangle its impact, we harnessed our proprietary factor library to take a factor-based approach that could clarify the diversification benefit of quality.

"Moreover, we defined four economic cycles to assess the payoff of quality. We group quality into subcategories and to assess its impact across multiple metrics.

"Our analysis found differing effects across the economic cycle. While investors can't systematically call the right cycle, diversification can certainly help them to navigate different environments.

"Diversification should not only be achieved combining different styles (such as quality, value and growth) but, as we have shown, investors can realise it within quality by choosing stocks aligned with factors from different subcategories."