Time to Stock up on Quality?

“Quality” stocks are said to offer a measure of portfolio stability ― a trait that becomes more valuable when markets are volatile and/or the business cycle is growing older. Both are true today. Tony DeSpirito offers his take on investing for quality.

It almost sounds intuitive that you’d want to own a quality stock. Why would you choose an inferior product in any scenario, particularly if cost were not a prohibitive factor?

I am a believer in and perennial practitioner of quality investing. It’s an enduring theme across our fundamental equity platform, given its relevance to both growth and value investors. It is of particular importance to the BlackRock Equity Dividend Fund, where we target strong businesses with the ability to grow dividends.

As the economic and business cycles age, we believe a focus on quality is increasingly important across the board as a means to enhance portfolio resilience. The market gyrations this month have offered another reminder of why quality matters.

A time for quality?

The VIX index, a common measure of stock market volatility, rose from a sedate average of 13 in July to nearly 20 in the first half of August. We find companies displaying quality characteristics such as strength in balance sheets and free cash flow are better able to weather such bouts.

While the current moment argues well for quality, I have found it to be a worthy proposition from a long-term risk/reward perspective regardless of the environment. Yes, there are times when it will work less well: Quality tends to under-perform in sharply rising markets, such as when the economy is coming out of a recession. At times like these, riskier lower-quality companies with higher leverage tend to outperform as they surge from their beaten-down state.

But a look at the chart below shows quality held an edge in the throes of the last recession (mid-2007 through early 2009), and also has outperformed during the bull market that followed.

Bottom line: Quality stocks may forfeit some incremental return in big market bounces, but history suggests they also are likely to lose less in the inevitable falls. This, on a net basis, makes them better investments over the course of a full cycle, we believe.

Quality stocks particularly stand out today. The fact that we are late cycle and markets are being rocked by U.S.-China trade noise and the vagaries of an election cycle tells me we may be in for a continued period of heightened volatility. A focus on quality stocks can allow investors to stay in the market to benefit from potential upturns, but with a measure of prudence built in to buffer downturns.