Quality Investing: Building Resilience and Growth Through Market Cycles (updated)

What Does “Quality” Mean in Investing?

In investment terms, quality refers to companies with strong, stable business fundamentals. While there’s no single definition, quality stocks typically share traits such as:

• High profitability and returns on capital: e.g. robust return on equity or high return on invested capital (ROIC). As legendary investor Jeremy Grantham put it, “The essence of a Quality stock is a high, stable return on equity and an impeccable balance sheet.”
• Consistent earnings and cash flows: low earnings volatility across the business cycle, showing that the company can perform in both boom-and-bust economic regimes.
• Strong balance sheets: low debt levels and healthy interest coverage, which give the company staying power and flexibility.
• Competitive advantages (“moats”): intangible assets like powerful brands, patents, network effects, or efficient scale that protect profits from competition.

In short, quality companies are the “blue chips” that combine steady profits with prudent management. Think of household names that reliably grow their earnings and dividends year after year. Many firms in our portfolio fit this profile – for example, Procter & Gamble has paid a dividend for 135 years and raised it for 69 consecutive years, a feat only possible for a stable, high-quality business. These companies often have wide moats; for instance, Coca-Cola’s world-class brand and distribution network gives it pricing power, helping protect margins even during inflationary or weak demand periods. Such traits make quality stocks attractive as long-term, buy-and-hold investments.

The Quality “Anomaly” – Higher Returns and Lower Risk

One might expect that safer, more stable companies would offer lower returns (as higher stability usually comes at a cost). Remarkably, quality investing has defied this notion. Academic and industry research finds that quality stocks tend to outperform the broader market while also showing lower volatility and shallower drawdowns [see graph below]. This is sometimes called the “quality anomaly.” In fact, one study noted that a portfolio of the highest-quality global stocks (with high profitability, low earnings variability, and low leverage) delivered 3% better annual returns than the market with lower volatility – an “utterly counterintuitive” result that challenges efficient-market theory. Over the long run, the quality factor has earned a persistent premium: for example, from the 1960s through 2023, a long-short “Quality Minus Junk” factor produced roughly a 4.7% annual excess return (with a healthy Sharpe ratio around 0.5).

What explains this? There are behavioural and risk-based theories, but a simple rationale is that quality companies’ steady compounding eventually shines through, even if investors sometimes undervalue stability in favour of more speculative stories.

Quality firms may not be the hottest names in a speculative frenzy, but their compounding of earnings and dividends creates substantial shareholder value over time. In essence, with quality stocks investors can “have their cake and eat it too” – enjoying strong returns and smoother rides. This combination is a big reason we emphasize quality in our core strategy.

Navigating Rolling Cycles of Performance

Even though quality wins in the long run, it’s important to acknowledge that no investment style outperforms in every single period. Quality as a factor goes through cycles of relative strength and weakness – what we might call “rolling alpha cycles.” Recognizing these patterns can provide context (and comfort) when short-term results deviate from expectations.

Historically, quality stocks tend to outperform during market downturns and late-cycle phases, but they can lag during the early stages of economic recoveries. This makes intuitive sense. In a recession or bear market, investors flock to safety and reliability – and companies with sturdy profits and balance sheets hold up better (their earnings fall less, and their stock prices decline less). Once the economy hits bottom and a new expansion begins, the “junkier” or highly cyclical stocks often rally the most off the lows – these are companies that were beaten down and suddenly benefit disproportionately from renewed growth or easy liquidity (“a rising tide lifts all boats”). During that initial rebound, high-quality stocks may underperform simply because they didn’t fall as far to begin with, and investors start chasing more aggressive gains.

Quality tends to shine in bear markets (rising blue line during red-shaded drawdowns) and lag slightly in early recoveries (blue line dips during green-shaded recovery periods). Outside of those phases, quality stocks generally keep up or outperform the market.

Source: Wisdomtree

However – and this is key – these bouts of underperformance by quality are typically short-lived and modest. Research shows that aside from roughly the first 6 months off a bear-market bottom, quality stocks outperform through most of the market cycle. An analysis by WisdomTree illustrated that quality’s biggest outperformance occurs in recessions and late-cycle markets, while any underperformance in early-cycle recoveries is relatively small by comparison. Moreover, quality’s drawdowns tend to be less severe than the broader market – it is often called an “all-weather” factor for its ability to add value in many environments.

Recent history bears this out. For example, during the 2020 COVID-19 crash, quality stocks held up much better than most, cushioning the portfolio. In the exuberant rally that followed, some riskier assets briefly outpaced our high-quality holdings. But as the cycle wore on into 2021–2022 (and inflation and rate hikes tested companies’ mettle), quality leadership returned. It’s normal for quality to experience periods of underperformance, especially immediately after a major downturn. Yet those who stay patient are often rewarded when quality’s inherent strengths drive a return to outperformance. The key is to remain focused on the long-term trend, not any single quarter or year. Our confidence in the quality approach is grounded in decades of evidence and experience: quality’s “alpha” may wax and wane, but it has always come back. Notably, quality – as an investment style – is experiencing its largest underperformance since 2009 [see graph below].

Why Quality Wins Over Time: Earnings Resilience and Compounding

What ultimately underpins the quality factor’s success?

The answer lies in the real-world performance of quality businesses. High-quality companies tend to grow earnings and cash flows consistently through all phases of the cycle, which in turn drives their stock prices higher over time. Even when their share prices occasionally lag in the short run, their fundamental progress continues unabated, setting the stage for future gains. Here are a few reasons quality companies continue to thrive and why their stocks compound value:

Durable Earnings: Quality firms often have products or services with steady demand. For instance, people keep buying household staples (like P&G’s toothpaste or Coca-Cola’s beverages) in any economy. Many of our technology holdings provide essential services (consider how Microsoft’s software or Alphabet’s Google services remain integral to businesses and consumers regardless of the cycle). This translates into earnings that might slow but don’t collapse in recessions. Case in point: even during the deep 2008–2009 recession, Visa – one of our portfolio companies – managed to grow its profits by 35% in early 2009 as the shift from cash to card payments continued unabated. Such resilience is common among top-quality firms.

Strong Balance Sheets = Survival and Opportunity: High-quality companies usually have low debt and ample liquidity, which lets them weather storms and even invest when weaker rivals cannot. This was evident in 2020: many quality companies had the resources to endure lockdowns, retain talent, and invest in future growth (new products, strategic acquisitions, etc.). Meanwhile, heavily leveraged companies were forced into distress or dilutive equity raises. The end result is that quality businesses often gain market share in tough times, widening their moat. In short, quality firms not only survive recessions – they can come out stronger.

Consistent Reinvestment and Innovation: Because of their stable profits, quality companies can continually reinvest in their business – funding R&D, marketing, and strategic projects to drive future growth. This virtuous cycle keeps them at the forefront of their industries. A great example is Accenture, a company we hold: its solid cash flows allows it to invest in new service capabilities (like artificial intelligence expertise) and to acquire smaller firms, ensuring it stays a leader in consulting. Similarly, Apple and Microsoft relentlessly invest in innovation and have transitioned through technological shifts (from PCs to cloud to AI) while maintaining strong profitability. As a result, they remain dominant – proving the adage that “high-quality businesses tend to remain high quality even during periods of technological change or rapid innovation.” Their competitive advantages are not easily eroded, so they keep delivering growth year after year.

All these factors contribute to a powerful outcome: high-quality companies can compound value year after year, often at an above-average rate. Crucially, this compounding tends to be structural and persistent. A 2015 study in the Journal of Applied Corporate Finance found that one of the only financial metrics that consistently predicted long-term stock outperformance was high Return on invested capital (ROIC). Companies able to sustain high ROICs over multiple years delivered continuous alpha for investors – effectively, “the gift that keeps giving”. In other words, if you can identify businesses that have both outstanding quality metrics and the ability to maintain those high-quality attributes over time, the rewards compound exponentially. This insight is at the heart of our strategy: we seek to own exactly those kinds of companies – those with proven and enduring quality – and let the power of compounding do the heavy lifting.

Visa’s earnings profile indexed to its share price since its listing has been nothing more than incredible. Note the share price decline in 2022 even as earnings continued to grow.

Procter & Gamble has consistently rewarded shareholders with dividends over time. Note the period after the global financial crisis where the share price moved sideways for over 4 years despite the dividends increasing 60% over this same period.

Back to fundamentals

Our Quality Portfolio is built on the belief that long-term investment success comes from owning companies with the ability to grow earnings faster than the broader market. We focus on businesses with durable competitive advantages, strong balance sheets, and consistent profitability-companies that can compound value over time. However, in the short term, market prices can deviate from fundamentals, particularly when large-cap stocks dominate overall market performance. These temporary dislocations can create opportunities for patient investors, as we remain confident that, over time, share prices will ultimately reflect the superior earnings growth of high-quality companies. Graph 1 illustrates the current environment, where the portfolio’s return has begun to diverge from its underlying earnings growth, while the broader MSCI World Index has increasingly moved away from its own underlying earnings power.

Graph 2 highlights the rolling five-year forward earnings growth of both the Core Quality Portfolio and the MSCI World Index. Three key observations stand out. First, the Core Quality Portfolio has consistently delivered higher and more stable earnings growth—even through challenging periods such as 2020 and the 2022 bear market. This reflects our focus on companies with durable business models and predictable earnings streams. Second, since 2024, there has been a noticeable step change in the MSCI World’s earnings growth, largely driven by the strong performance of the hyperscalers (the so-called “Magnificent 7”). Lastly, the MSCI World only has a 31% success rate in terms of earnings growing in excess of CPI +5% whilst the Core Quality portfolio has a 100% success rate.

This concentration has narrowed the gap between the two series’ earnings growth rates. While short-term market dynamics can shift the relative picture, it’s important to focus on what we can control. We continue to invest in businesses with reliable earnings growth, durable competitive advantages, and robust balance sheets. What we cannot control is the market’s short-term valuation of equities-especially when sentiment and momentum dominate. Nonetheless, we maintain our conviction that, over time, prices ultimately follow earnings, and quality companies will continue to reward patient investors.

Is it unique to our strategy?

What happened to the quality premium?

Until mid-2024, the “quality premium” – that is, how much more investors are willing to pay for high-quality companies over the broad market – had blown out to as much as 20–30%. Since then, that premium has deflated sharply, sliding from around 29% in June 2024 back toward its long-term average of ~15%.

In plain terms: for a while, markets were paying a heavy markup for “quality” characteristics. Now those skies are clearing. That doesn’t mean quality is no longer valuable – far from it – but the valuation buffer that once felt generous has largely eroded.

What this suggests for today’s investor: if you believe quality traits (strong earnings, low leverage, resilience in volatility) offer genuine defensive value, you may be entering from a more reasonable valuation than you would have two years ago. Just remember – premium compression can go both ways. As we enter the next leg of the market cycle, the distinction between quality and “just expensive” may be tested yet again.

How has the average quality alpha manager done?

Graph 4 highlights how a group of 11 respected global managers – all focused on high-quality companies – have significantly lagged the broader market. This isn’t just a reflection of one approach or methodology; it shows that the entire “quality” style of investing is under pressure. In recent years, markets have favoured faster-growing and more speculative companies, while investors in stable, well-managed businesses have been left behind. Even though quality stocks tend to shine in uncertain times, the current environment has rewarded risk-taking and short-term momentum instead.

However, the story isn’t all negative.

Periods of underperformance for a particular style are normal and often cyclical. Quality investing – focusing on strong balance sheets, steady profits and prudent management – has a long track record of delivering consistent returns over time. While today’s gap between quality managers and the market may look uncomfortable, it could also be setting the stage for future opportunity as markets eventually rotate back toward fundamentals. In other words, patience and diversification remain key, even when the market’s “eye-sore” chart seems to suggest otherwise.

Looking Ahead: Why We Remain Confident

It’s understandable that clients may feel uneasy when a strategy like quality investing goes through a soft patch. After all, quality stocks – by their nature – often don’t feel “exciting” in the short term. In a roaring bull market led by speculative names, steady compounders can seem dull by comparison. Lately, factors like momentum or specific thematic plays (e.g. AI-related tech) have grabbed headlines, and our quality-oriented approach may not always capture those short-lived surges. However, this is by design. We deliberately have an allocation towards proven, enduring businesses rather than chasing each market fad with the client portfolios. Why? Because over full cycles, quality remains a stay rich strategy. The data is compelling and spans decades: high-quality companies tend to remain high-quality, and their stock returns mirror the persistent growth in their intrinsic value. Meanwhile, lower-quality companies that might skyrocket in one phase often cannot sustain their performance when conditions change.

Our role, as long-term stewards of your capital, is to ensure that the core of your equity portfolio is built on rock-solid foundations. By holding a collection of world-class businesses – the “compounders” that generate superior returns on capital and have durable advantages – we tilt the odds in your favour. These companies navigate inflation, recessions, and technological disruption from a position of strength. They may not be immune to market volatility (no stock is), but they tend to recover faster and reach new highs sooner, propelled by fundamental results.

It’s also worth noting that after periods when quality underperforms, history suggests strong rebounds tend to follow. Just as night follows day, the market eventually refocuses on earnings quality and stability, especially if turmoil arises. We’ve already seen some signs of this rotation: for instance, as the post-COVID speculative fever cooled, investors rotated back into quality in 2022–2023, and quality stocks led the market in 2023. Market leadership is often cyclical, and we believe the quality factor is poised to deliver robust returns as the cycle progresses.

In summary, we remain highly confident that a healthy allocation to a quality-focused strategy is the right path for long-term wealth building and capital preservation. Sticking with high-quality companies through the ups and downs requires patience, but it has rewarded investors with superior risk-adjusted returns over time. As the saying goes, time in the market beats timing the market – and time with quality businesses is perhaps the most rewarding of all. By holding onto our portfolio of blue-chip, buy-and-hold companies, we are not just weathering the current cycle; we are positioning ourselves to thrive in the next phases and beyond. The combination of these firms’ steady earnings growth, financial resilience, and shareholder-friendly policies should continue to drive attractive returns for us. After all, “the gift that keeps on giving” from high-quality holdings can richly reward those who stay the course. Here’s to the continued resilience and success of the quality companies in our portfolio – and to our success as their long-term shareholders.