In times of stress, quality should prevail

Having recently returned from a trip to Europe, I was able to witness firsthand some of the impacts that a slowing of global growth and negative interest rates (to name two) can have on investment markets and an economy in general.

When I read that the Future Fund is in negotiations with the Federal Government to lower and adjust the longer term investment return targets of this $120 billion investment vehicle, the tag line of ‘lower for longer’ starts to repeat itself.

Additionally, there have also been many non-financial events around the world that will challenge us, maybe not all directly financial, but that will test us none the same.

In times like this, many investors might feel the need to move to the relative safety of cash (?), but with record low rates around the world, this will  not be without risk – the risk of underperforming (net of taxes) the cost of living (inflation).

While no ONE investment or investment manager offers the panacea to the investment world’s woes, there are options to consider in portfolios.

I recently caught up with one of the vice-presidents of Market Vectors to discuss our global concerns. As part of our discussion, we were looking at investment options that;     

• have outperformed in the current low growth and low inflation environment;
• investing that avoids leverage and the ‘irrational exuberance’;
• defensive characteristics during market downturns; and
• investments that have ‘lost less and recovered faster’.

Nick shared his comments with me.

Quality has prevailed during the recent global share market turmoil. The current global environment continues to be characterised by low growth, low inflation and share market volatility.  These conditions highlight the case for Quality investing.

Comparing the standard MSCI World ex Australia Index to the Market Vectors MSCI World ex Australia Quality ETF (QUAL) since the beginning of the year, shows that while Quality stocks are not immune from falls, they have fallen much less.

Quality has prevailed during the recent global share market turmoil. The current global environment continues to be characterised by low growth, low inflation and share market volatility.  These conditions highlight the case for Quality investing.

Comparing the standard MSCI World ex Australia Index to the Market Vectors MSCI World ex Australia Quality ETF (QUAL) since the beginning of the year, shows that while Quality stocks are not immune from falls, they have fallen much less.

Source: Morningstar Direct. 1 January 2016 to 16 February 2016. The calculations for the above include the reinvestment of all dividends. QUAL data includes management costs but not brokerage expenses associated with an investment in the fund. You cannot invest in an index. Results reflect past performance and do not guarantee future results of the index or the fund.

Avoiding leverage and the ‘irrational exuberance’

Quality gained investors’ attention as an investment strategy at the beginning of this century as it avoided the dot-com crash and high profile failures such as Enron and WorldCom. Since then, in swinging up and down markets the go-to strategy has been investing in profitable companies with strong balance sheets and low earnings variability.  It is for these reasons that QUAL is currently underweight financials.

Weak balance sheets were put under pressure during the GFC, often resulting in government intervention.  Now global banks are hamstrung by the need to raise capital during a time of low equity prices to meet more stringent regulatory requirements and operating rules.  Banks in Europe and the US have been under pressure since the GFC and their share price performance has been reflective of that.

Source: Thomson Reuters (as cited by stansberryresearch.com)

Quality offers defence

MSCI’s Quality approach has demonstrated significant outperformance in down markets and has outperformed over the long term with less volatility.

Source: MSCI, Market Vectors. Results include the reinvestment of all dividends but do not include management costs or brokerage expenses associated with an investment in the fund. You cannot invest in an index. Results reflect past performance and do not guarantee future results of the index or the fund.

Quality companies have lost less and recovered faster

No investor wants to lose money and timing the top or bottom is nothing short of miraculous. To understand how a strategy could perform in the current environment a risk measure called ‘drawdown’ demonstrates both the depth of a fall from an historical peak and the pace of the recovery to a new peak.  The maximum drawdown is the distance from the highest peak to the deepest valley.  Investments that fall less and recover faster are more desirable.

The chart below shows the drawdown of the QUAL’s Index versus the broader MSCI World ex Australia Index for the past ten years capturing the GFC.  In summary:

• The maximum drawdown of the QUAL Index was 24.28% versus MSCI World 37.79%
• The pace of recovery of the QUAL Index was eight months faster.

Source: Morningstar Direct. The calculations for the above include the reinvestment of all dividends but do not include management costs or brokerage expenses associated with an investment in the fund. You cannot invest in an index. Results reflect past performance and do not guarantee future results of the index or the fund.

With all investments, Financial Keys and the investment research team undertake detailed analysis on all investments before recommending any investments.

Investing in a low growth and low inflation environment will offer up challenges, which is part and parcel of the day-to-day life inside any active advisory office, like Financial Keys. 

The key takeaway points from this type of investment would be

1. QUAL is an ASX listed ETF that, via a single ASX trade,  provides investors with an international equity portfolio of the 300 highest Quality companies included on the basis of:

1. High ROE; 
2. Stable year-on-year earnings growth; and
3. Strong balance sheets.

1. Quality companies demonstrate outperformance in a low growth/low inflation environment.
2. With one trade, QUAL provides access to 19 developed countries including US, UK and Japan.  Overweight sectors include healthcare and information technology.