Pierre Debru, Head of Quantitative Research & Multi Asset Solutions, WisdomTree gives us his thoughts on Quality Stocks.
2023 saw one of the narrowest bull markets in history, with only 10 stocks contributing 14.3% out of the 20.6% rally during the first 7 months of the year.
Since then, markets have turned with the S&P 500 and the MSCI World dropping around -7% since their top [1].
Looking forward to the rest of 2023 and beyond, uncertainty is high:
- The Federal Reserve (Fed) has reached or is nearing the end of its rate hike cycle, but the easing cycle is still distant and its speed is unknown.
- The US may avoid a full-blown recession but a recessionary environment with below-average growth is still on the table.
- Further disinflation may be slower as we get closer to target, and energy prices continue to put pressure on core CPI.
In such uncertain times, investors could be contemplating reducing risk in their portfolios. However, many of them have been caught with an underweight in equities early in 2023 and missed out on the rally, leading to underperformance. To avoid a repeat, remaining invested but shifting equity exposures toward higher quality, dividend growing stocks could help protect the downside while maintaining exposure to the upside.
Quality stocks tend to outperform at the end of rate hike cycles
With the rate hike cycle reaching its end, it is interesting to see what happened historically to equities in the 12 months following the end of rate hike cycles. Figure 1 shows that the absolute performance of US equities has been quite dispersed following the end of the last 7 rate hike cycles by the Fed. US equities returned 24% in the best period and -18.8% in the worst. Looking at high quality stocks, we observe some consistency, though, since they outperformed the market in 6 out of those seven periods. The only period of outperformance was in 1998, when quality companies returned ‘only’ 23.3% versus 24.3% for the market. In the two periods when equities posted negative returns, quality companies cushioned the loss well, reducing the drawdown significantly.
Figure 1: Performance in the 12 months following the end of the Fed’s last 7 rate hike cycles
When investors get picky, quality stocks benefit
Figure 2 focuses on the performance of high and low quality stocks depending on the level of growth in the economy. We split quarters into 4 quartiles, from low-growth quartiles to high-growth quartiles, and then calculate the outperformance or underperformance of those stocks in the quarter following the growth observation.
We first observe the resilience of high quality stocks. While low-quality companies only outperform when the economy is firing on all cylinders, high quality stocks outperform in all 4 environments. High quality stocks outperform more when growth is either low or below average.
Figure 2. Average outperformance of high-quality and low quality stocks depending on US GDP growth
Quality is the style that doesn’t go out of style
Investment factors ebb and flow between periods of relative under- and outperformance, depending on where we are in the cycle. One big exception is quality which is, in our view, the most consistent of all factors. Sure, quality can lag in the sharp risk-on rallies that typically mark the start of an early cycle snapback; but those environments don’t tend to last, and neither does quality’s underperformance. In fact, there hasn’t been a rolling 10-year period when quality underperformed since the late 1980s.
Figure 3 exhibits the rolling outperformance of different US equity factors versus the market over 10-year periods since the 1970s based on the data from a famous academic: Kenneth French. On average, over periods of 10 years, quality is the factor that has historically delivered outperformance the most, often by a significant margin (90% of the time, the second best only hit 78%). It is also the factor that exhibited the smallest worst performance.
Figure 3: Rolling 10 year annualised excess returns of US factors versus the market
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Small Cap | Value | Low Volatility | High Dividend | Quality |
| Percentage of Outperforming periods | 59% | 75% | 78% | 72% | 90% |
| Best Outperformance | 11.9% | 9.1% | 5.0% | 6.7% | 2.7% |
| Worst Underperformance | -7.3% | -5.7% | -4.4% | -5.7% | -1.4% |
Sources: WisdomTree, Ken French, data from June 1963 to 31 July 2023 and represents the latest date of available data. Value: High 30% Book to Price portfolio. Size: Low 30% portfolio. Quality: High 30% portfolio. Low Vol: Low 20% portfolio. High Div: High 30 portfolio. Market: all CRSP firms incorporated in the US and listed on the NYSE, AMEX or NASDAQ. Historical performance is not an indication of future performance, and any investments may go down in value.
Conclusion
Overall, high quality stocks have exhibited outperformance in periods of low growth, in periods following rate hikes and, more generally, across many parts of the business cycle. With economic uncertainty remaining elevated, and an equity rally that is faltering, investors could consider quality as their portfolio anchor.
[1] Source: WisdomTree, Bloomberg. As of 27 September 2023.This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.
