Investment Strategies: Quality Investing: Time to Shift Gears?

In cricket lingo, we have often heard that “The form is temporary, the class is permanent.” This is because consistency in a cricketer’s performance across multiple formats over a long period is more important than exceptional performance in a few matches. Similarly, when it comes to investing, strategies that work consistently over a long period help investors achieve their long-term goals. investment objectives.

Quality investment Build a portfolio of great companies based on solid financial metrics and a stable balance sheet. Nifty 200 Quality Index 30 It is a factor-based smart beta index, which builds a portfolio of 30 high-quality companies, selected based on three factors, namely: return on capital, healthy balance (Low debt/equity ratio) and consistency in earnings growth (Low variability in annual EPS growth over the last 5 years) of its parent index i.e. Nifty 200 index.

The performance of the Nifty 200 Quality 30 index (RoE of 36%) has been relatively better than that of the Nifty 200 index (RoE of 20%).

Big hitters can perform well in tough playing conditions. Also, due to strong and consistent financial performance, quality companies are relatively resilient during market downturns as the quality index has witnessed minor declines during market corrections. The Nifty 200 Quality 30 index has fallen by 28% compared to the 37% fall in the Nifty 200 index during the Covid pandemic (February 7 to March 23, 2024). The Quality index has delivered a significant outperformance of 4.30% on an annualized basis since April 2005, which helped in higher wealth compounding for the Quality index by 31.2x versus 15.4x for the Nifty 200 index, as shown in the table.

Why change gears now?

Rotation of styles It is a key feature of equity markets. Quality and value are two contrasting strategies where one tends to outperform the other based on market cycles and the macroeconomic environment. The past 4 years have been favorable for the value style, mainly due to a relatively attractive valuation and the recovery in the macroeconomic environment, which began in mid-2020. The chart below highlights the relative performance of the quality index compared to the value index on a consecutive year basis. It shows that the styles continue to rotate periodically, with the quality style outperforming from February 2018 to January 2021 and thereafter, the value style outperforming year-to-date.

Similarly, analysis of the ratio of the quality to value index also demonstrates the rotation between these two styles. Historical data spanning about 20 years suggests that the quality style has delivered a relatively better performance following periods of extreme outperformance by the value style. During the up cycle of the quality style, its performance has been significantly better than that of the value style as well as the broader market index. The last up cycle of the quality index, which began in May 2017, lasted till October 2020, returned 51%, outperforming the Nifty 200 index which returned 26%, while the value index has fallen by 42% in this phase. The current ratio of quality to value, which is closer to the previous lows (May 2017), indicates a reversal in the quality style and is showing early signs of recovery in performance in 3 months.

ETMarkets.com

Coming back to my initial statement, a player’s strong track record is determined based on the consistency of performance across all formats over a long period; similarly, in long-term investment, consistent performance along with lesser drawdown during market correction are crucial to achieve long-term investment goals.

The Nifty 200 Quality 30 Index is a factor-based smart beta index that constructs portfolios of thirty high-quality companies. This strategy has shown consistent performance against its parent index i.e. the Nifty 200 Index. It has outperformed the Nifty 200 Index 88% of the time over a consecutive 5-year period, with a minor drawdown during market corrections.

Style rotation is a key feature of stock markets; the past four years have been favorable for value investing And if the style rotates, it can favor the quality style in the short to medium term. Therefore, this strategy offers investors the opportunity to add style diversification to their portfolios, potentially improving long-term returns and reducing risk by focusing on high-quality companies.

Legal notice: data since its creation, from April 2005 to July 2024

(The author is a fund manager and responsible for passive, arbitrage and quantitative strategies at ITU AMC. Opinions are my own)