Quality During Times of Uncertainty

Economic uncertainty and market turbulence often come when they are least expected. Uncertainty begs the question – how should investors, who know holding equities is the right long term strategy, protect their portfolios against periods of volatility? 

In this blog we explore one approach - focusing equity allocations on quality companies that offer resilience in times of market stress.

Key Takeaways

• Quality is hard to define and generally encompasses companies that score high on profitability, safety, and quality of earnings.
• Quality investing is a persistent source of outperformance over the long run. This result is robust and well explained by a consistent underestimation of these companies especially those that benefit from barriers to new competition i.e. a moat.  
• During periods of economic uncertainty and market turbulence, quality companies tend to outperform due to the resilience of business fundamentals.
• Tema’s approach to quality, focusing on durable, dominant, and tangible moats not only harnesses the long term quality premium but potentially benefits from more protection during market volatility.  
• The TOLL portfolio offers superior fundamental metrics at a valuation discount to the market, which could serve investors well as market uncertainty prevails.

What is a Quality Stock?

Quality is hard to define. Quality companies are generally seen as having the following traits rooted in fundamental analysis and roughly grouped in profitability, safety, and quality of earnings:

• Low earnings volatility
• Stable earnings growth
• High margins and profitability
• High asset turnover i.e. efficient use of assets
• Low financial leverage
• High accounting quality
• High returns on invested capital
• Share count shrinkage
• Well managed

Quality Investing Works Over the Long Run and There are Good Reasons Why

The literature is rich with analysis that shows how well quality companies work over long periods of time. Companies with high earnings quality earn a premium which is “one of the most robust long-term patterns documented in the literature”. In a paper¹ researchers at Yale found, that over 1988-2012 the quality companies generated a Sharpe ratio of 0.69, much higher than other factors, including the famous value factor. This is robust out of sample suggesting that returns are not arbitraged away. Returns are further improved by using a composite quality factor (that includes several features of quality).

“The so-called “quality anomaly” is one of the capital markets’ strongest reported anomalies and has a long tradition among investors”

Other work confirms these results. In this paper² practitioners documented a Sharpe ratio of 1.2 over 20 years for a quality portfolio that looks at companies with high returns on assets (ROA) or high operating cash flow to total assets.

In an efficient market, such persistent risk adjusted returns of quality companies should
not exist. There are several hypotheses on why this anomaly persists:

• Quality is objectively desirable and the rational stock market participant would assume such companies would trade at a premium, hurting future returns. Interestingly, this premium is found by AQR to be modest³ and could explain high risk adjusted returns.
• Analysts could also underestimate quality consistently in the market. There is a temptation to fade quality metrics like growth rates and returns, due to competition or even “The law of large numbers”. Quality companies that continue to deliver beat expectations creating persistent outperformance.
• Some quality firms benefit from moats. These companies operate with barriers to new competition that mean their returns persist much longer than expected. Identifying moats is difficult but they harness the most durable part of the quality premium.

Quality Investing’s Best Feature is Resilience in Recessions

Quality stocks have higher earnings visibility and more recurring revenues that cushion weaker cyclical environments. Even those that depend on cyclical sectors, like housing or manufacturing, are often so well managed that they take advantage of weakness around them to invest against the tide. Having strong balance sheets also helps to avoid any unwanted financial strain.

The effect of these features, means quality companies strongly outperform in periods
of recession, as can be seen in the chart below. During the mid and late cycles quality
companies also show good outperformance and risk adjusted returns. Quality companies do tend to underperform during early cycle stages when other parts of the market do better. Despite this variability a key takeaway from this chart is how since 1975 the long run excess returns are highly positive.

Quality’s Relative Performance Over Business Cycles

Quality Companies Also Do Well in Bear Markets

Data also suggests that quality companies tend to perform well in down markets. These
companies exhibit defensive characteristics, explained by a flight to quality during tough market environments. Since 1927, the US stock market return was positive 72 years and negative 24 years. In those 24 negative years quality companies where the best performers delivering +10.7% against an average market risk premium of -18.2%⁴.

This return profile can be even stronger during crises. For example, during the global
financial crisis, quality stocks posted nearly 24% annualized returns and a Sharpe ratio of 2.86, a result that is consistent across other crises⁵.

Quality With an Eye for Valuation Tends to Do Even Better in Bear Markets

A long-term study of quality investing by GMO during all periods and bear markets found that applying fundamental valuation provides another source of outperformance.

High-Quality Wins Over Time with Lower Risk

Tema’s Approach to Quality Has the Potential to Offer Better Protection During Volatility

Tema’s TOLL fund invests in a subset of quality companies. The approach picks firms with durable, dominant, and tangible moats – barriers to potential competition - with the aim of selecting companies where quality endures. These features make for potentially better protection during market volatility. Why?

• Durable. By emphasizing a universe with longevity, the fund skews towards stocks with more recurring revenues which offer protection during downturns. This means lower volatility in quality investing.
• Tangible. A universe of tangible moat companies, like infrastructure, tend to hold their value due to the essential nature of the service they provide. Intangible value can be more cyclical because it relies to a certain extent on the market sentiment which goes down during recessions.
• Dominant. A strong market position, won through consistently delivering value for customers through mission critical products and services, is a great platform to weather storms. This can be used to invest counter cyclically. The reverse also holds – more competitive industries usually struggle the most in downturns as competitors fight fiercely for a diminishing pool of revenue.

These benefits are reflected in financial metrics. The table below compares TOLL to the
broader market as well as a recognized quality index. Across all but one quality metric
TOLL’s current portfolio is superior. During the period represented in the table, despite clear superiority, the portfolio traded at an 18% discount to the S&P 500 in valuation terms.

TOLL's Portfolio Boasts Strong Quality Metrics at a Lower Valuation Than the Market

Bottom Line

Quality companies can provide investors with a long-term source of outperformance. This is especially true during periods of market instability. Tema’s approach to quality investing aims to harness quality and potentially offer more resilience should macro clouds darken.

Disclosures

For the fund's current holdings, visit the fund detail page.

Risk Information

Carefully consider the Fund’s investment objectives, risk factors, charges and expenses before investing. This and additional information can be found in the Fund’s prospectus or summary prospectus, which may be obtained by visiting www.temaetfs.com.

Read the prospectus carefully before investing.

Diversification does not ensure profits or prevent losses.

Investing involves risk including possible loss of principal. There is no guarantee the adviser’s investment strategy will be successful.

Sector Focus Risk: The Fund may invest a significant portion of its assets in one or more sectors, including Engineering and construction, Financial Sector, FinTech, Industrials and Infrastructure, and thus will be more susceptible to the risks affecting those sectors than funds that have more diversified holdings across several sectors.

The success of the Fund’s investment strategy depends in part on the ability of the companies in which it invests to maintain proprietary technology used in their products and services. Companies in which the Fund invests will rely, in part, on patent, trade secret and trademark law to protect that technology, but competitors may
misappropriate their intellectual property, and disputes as to ownership of intellectual property may arise. Similarly, if a company is found to infringe upon or misappropriate a third-party’s patent or other proprietary rights, that company could be required to pay damages to such third-party, alter its own products or processes, obtain a license from the third-party and/or cease activities utilizing such proprietary rights, including making or selling products utilizing such proprietary rights. These disputes and litigations may be detrimental to performance.