Quality investing: The answer to outperforming growth in a recession (and even in the long term)

• The performance of high-quality companies in the long run cannot be understated. Over the past two decades, high-quality companies have outperformed the broader market by a significant margin. 

• High-quality companies tend to experience much smaller earnings per share (EPS) declines relative to other companies. They are also less likely to see drastic negative revisions to EPS estimates, which can help to support valuations. 

• High-quality companies have also proven to have a lower maximum drawdown even during recessions.

• The current macro backdrop remains supportive of quality. Higher-for-longer inflation and interest rates are pushing the US economy to the brink of a recession. These are times when exposure to high-quality companies may be beneficial to investors’ portfolios.  

• Investors can add exposure to the quality factor via the JPMorgan US Quality Factor ETF (NYSE:JQUA).

Amidst the market volatility over the past few months, the quality factor has continued to perform well. Over the past three months, the MSCI USA Quality Index managed to deliver returns of 7.06%, whereas the MSCI USA Growth Index and the MSCI USA Index had returns of -2.69% and 4.91% respectively (Table 1). As a matter of fact, the quality factor has also managed to deliver strong performance over the long term, having outperformed the broader equity market and even the growth factor by a significant margin over the past two decades (Figure 1). 

Table 1: Quality stocks have held up well amidst the market downturn this year  

Figure 1: Quality has outperformed the broader equity market over the past two decades. 

Aside from the well-known duo of value and growth, quality is another widely used investing style, especially during periods of high market volatility. It can be defined as buying companies with durable long-term profitability, minimal solvency and financial risk, and high earnings quality. Quality can also be described as "defensive", given that it is typically more resilient during times of market stress, especially during the later phase of the economic cycle (such as now). 

(Related Article: A global recession is likely unavoidable in 2023. Here’s how you can prepare for it.)

Given our view that the US economy is headed for a recession in 2023, we believe that investors will be rewarded for taking on more exposure to the quality factor. In this article we lay out the reasons why, and also share our recommended ETF for exposure to US quality stocks. 

(Related Article: Navigate the US market turbulence with a Quality-focused strategy)

Companies with high-quality earnings tend to outperform during times of economic stress 

There are a number of reasons why quality stocks tend to outperform growth stocks or even the broader market during times of economic stress, and it all boils down to how these stocks are selected. For instance, the MSCI USA Quality Index aims to identify high-quality US stocks based on three fundamental variables, namely, high return on equity, low debt-to-equity, and low earnings variability (Figure 2). 

In the end, companies that are included within the index exhibit the strongest of these characteristics relative to their peers. The top 10 holdings include the likes of Microsoft (NASDAQ:MSFT), Visa (NYSE:V), and Apple (NASDAQ:AAPL), all of which have demonstrated consistent earnings power over time and are market leaders in their respective industries. 

Figure 2: The MSCI USA Quality Index screens for quality stocks using these three metrics 

Source: MSCI

Based on this screening methodology, it is obvious that a lot of emphasis has been placed on profitability and earnings quality, with two out of the three metrics taking this into account. This is important because share prices are ultimately driven by earnings growth in the long run. Companies with more sustainable earnings growth tend to see share prices appreciate in the long term. 

Looking back in time, we can see very clearly that companies with high-quality earnings tend to experience much smaller declines relative to other companies. For instance, during the early days of the Covid-19 pandemic back in 2020 and the current high inflation, high interest rate environment, the trailing 12-month earnings growth of quality stocks has declined by a much smaller magnitude relative to the broader market (Figure 3). Aside from this, high-quality companies are also less likely to see drastic negative revisions to earnings per share (EPS) estimates, which can help to support valuations. 

Figure 3: Earnings growth of high-quality companies tends to experience smaller declines relative to the broader market 

These companies typically have robust balance sheets and are thus better positioned to withstand economic downturns. Many of them also possess competitive advantages and pricing power, allowing them to pass higher input costs to consumers without suffering a substantial loss in demand (due to factors like demand inelasticity, brand power, and industry dominance), thus protecting their margins and earnings. 

Visa, for instance, operates on a massive scale and is deeply entrenched within the global financial system. That has allowed it to grow its EPS by a mind-blowing compound annual growth rate of nearly 30% over the past 10 years, in addition to its industry-leading profit margins. 

Aside from their resilient share price performance, the defensive nature of high-quality companies can also be observed from metrics such as their maximum drawdown. As seen from Figure 4, the MSCI USA Quality Index has a lower maximum drawdown than the broader market during times of economic stress, such as the dot-com bubble in 2001, the global financial crisis in 2008, and the Covid-induced recession in early 2020.

Figure 4: The MSCI USA Quality Index has a lower maximum drawdown relative to the broader market during times of economic stress

The bottom line is this: based on empirical evidence, high-quality companies do indeed outperform the broader market during times of economic weakness and uncertainty. As such, increasing one’s exposure to high-quality companies may help to buffer against any potential downturns as we head towards a recession. 

Current macro backdrop remains supportive of quality

Speaking of economic weakness and uncertainty, the health of the US economy has deteriorated by a great deal since the start of the year. Between the inverted yield curve, stubbornly high inflation, and a Federal Reserve that is aggressively raising rates, the US has been pushed to the brink of a recession. 

As of November 2022, the US Leading Economic Index (LEI) has fallen for nine consecutive months, with the latest reading coming in at -4.5% year-on-year (Figure 5). The sustained and sharp downturn of the LEI suggests that economic conditions have deteriorated substantially, and it is just a matter of time before the US enters a recession, if it isn’t already in one. 

Figure 5: US leading indicators continue to decline in October, pointing to a recession

Dissecting the numbers, November’s LEI reading was brought down mainly by weaker-than-expected consumer expectations for business conditions as high inflation and tighter monetary policy continued to bite. Looking ahead, we expect inflation to moderate as growth slows but it is unlikely to reach the Fed’s target of 2% in the foreseeable future. We believe that inflation is becoming more entrenched as the world moves into a new regime where structural forces will lead to a more persistent rise in inflation in the years ahead.

(Related Article: How long will it take for inflation to hit 2%? Hint: much longer than you think)

Among the various factors keeping inflation higher, an exceptionally tight labour market is perhaps one of the biggest culprits. In the US, there are roughly 1.7 vacancies for every person currently registered as unemployed (Figure 6). Non-farm payrolls rose by 263,000 in November, beating the median consensus forecast of 193,000 by a significant margin (Figure 7). The unemployment rate also remains low relative to historical standards. 

Figure 6: Despite multiple rate hikes, the US labour market remains robust

Figure 7: Nonfarm payrolls continue to beat estimates 

November’s jobs report also showed average hourly wages rising by 0.6% month-on-month – the highest since January this year – as workers continue to leverage their bargaining power amidst a tight labour market. Businesses will likely pass on the higher labour costs to consumers in the form of higher prices, adding to inflationary pressures. 

A robust labour market, coupled with stubbornly high inflation, leaves the Fed no choice but to continue tightening. During the December FOMC meeting, the Fed raised rates by 50 bps, bringing the upper bound of the Fed Funds Target Rate to 4.5%. This makes the 2022 rate-tightening cycle the most aggressive since 1988. To put things into perspective, rates have gone up by 425 bps in a span of nine months, a rate of change that far exceeds previous tightening cycles (Table 2). 

Table 2: The current rate-tightening cycle has been the most aggressive in recent times 

With inflation still far from the Fed’s 2% target, don’t count on them to take their foot off the tightening pedal anytime soon. This brings about another problem: the Fed overtightening and causing a deep recession. 

Looking at the way things are progressing, we believe that a US recession is likely unavoidable at this point. The strong earnings growth delivered by most companies post-pandemic will likely be unsustainable. High inflation and steep borrowing costs will put downward pressure on revenues and margins, leading to lower, or worse, negative earnings growth. These are times when exposure to high-quality companies may be beneficial to investors’ portfolios.  

(Related Article: A global recession is likely unavoidable in 2023. Here’s how you can prepare for it.)

Looking back at previous recession years when the MSCI USA Index registered negative earnings growth, we can see very clearly that companies with strong balance sheets, high-quality earnings, and stable cash flows were still able to deliver positive EPS growth for the most part, demonstrating their resilience when times are tough (Table 3).

Table 3: Year-on-year earnings growth/decline of high-quality companies relative to the MSCI USA Index  

All in all, in the current macro environment where high inflation and aggressive monetary tightening will likely lead to a recession, we believe that investors will benefit by incorporating some exposure to the quality factor in their portfolios. The quality factor also complements value investing, allowing investors to create a more balanced equity portfolio that can perform across a broad range of market environments. Our recommended ETF for exposure to US quality companies is the JPMorgan US Quality Factor ETF (NYSE:JQUA).

 This ETF aims to provide investors with exposure to a basket of high-quality US stocks by utilising a rules-based approach that matches the sector weights of the Russell 1000 Index and selects stocks based on quality and profitability characteristics. To make things even more enticing, this ETF has the lowest expense ratio among all its peers, making it a cost-effective way for investors to get diversified exposure to a basket of quality US names.