In the current macroeconomic environment, investors face an unprecedented confluence of challenges: Soaring interest rates, persistent inflationary pressures and the looming spectre of recession.
In such turbulent times, the need for a resilient investment strategy is paramount. One strategy is quality growth investing which emerges as a beacon of stability, offering a blended approach that aligns both value and growth investment methodologies as we deliberate on the effects of current economic conditions on capital market returns.
However, in this complex landscape, how can investors find a safe harbour? The answer may lie in the nuanced approach of quality growth investing.
Understanding quality investing
Assessing a company’s quality through the lens of an investor can be quite a nuanced task. Hence, academics and practitioners alike have agreed to disagree on what characteristics make up the quality factor. Well-established methodologies, however, highlight certain key traits:
1. A strong moat that enables a company to maintain its competitive advantages to help fend off competition and maintain profitability into the future.
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2. Competitive advantages that allow a company to sustainably generate high returns on capital and reinvest for similarly high returns to drive future growth.
3. A company that is able to maintain the sweet spot of continued revenue growth and ebitda margin.
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Moat investing
A company’s moat refers to its ability to maintain a competitive advantage in its industry, leading to sustained profitability into the future.
This concept is particularly important in a volatile industry where companies are continuously striving for dominance. Morningstar, a leading financial services firm, has identified five elements of a moat as follows:
Customers’ costs of switching: The costs of switching to a competitor, both tangible and intangible, give a company pricing power by locking their customers into its unique ecosystem.
Intangible assets: Intangible assets like brand recognition, patents and regulatory licenses make it difficult for competitors to duplicate products or undercut prices.
Network effect: Network effect refers to the impact that companies have when their products or services increase in value as the number of customers increases.
Cost advantage: Companies that have cost advantage when they are able to keep their costs lower than competitors, will have the power to command higher margins or pricing.
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Efficient scale: Companies enjoy efficient scale when they operate in a market that may only support one or a few competitors, with high barriers to entry. Identifying these high quality companies at attractive prices has shown outperformance relative to other major style factors over both the short and long terms.
Compounding high returns on capital
A company’s financial productivity is known as a critical driver of its earnings, which ultimately drives investment returns. Lazard, a financial advisory and asset management firm, defines quality companies as those that have competitive advantages which enable them to generate sustainably high returns on capital and actively reinvest them at similarly high rates of return for future growth. Companies with these specific characteristics are called “compounders”.
The compounding cycle starts when a company is financially productive and generates cash flow from invested capital. The company management then actively decides to reinvest this cash flow into growth opportunities that help to create an even larger capital base. The cycle then repeats itself with a higher cash flow from this larger capital base.
Quality stocks
Quality stocks have been underrated and underappreciated relative to value and growth stocks, which gained their popularity through academic roots and the appeal of outsized gains, respectively. Nonetheless, quality stocks have outperformed both their value and growth counterparts for decades, as shown in the chart below.
Revenue growth + profitability
One of the hallmarks of quality growth companies is their ability to deliver consistent revenue growth while sustaining ebitda margins, even in the face of economic headwinds. This track record demonstrates their ability to execute effectively and adapt to changing market conditions.
PhillipCapital uses a variation of the Rule of 40 (Three-year revenue CAGR + Ebitda margins > 40%), and several other key ratios to shortlist companies that are able to effectively balance their pursuit for growth with profitability while maintaining industry-leading positions in forward-looking markets.
Extensive research and back-testing show that not only did these shortlisted companies consistently outperform the overall market but they also generated above-average risk-adjusted returns across various industries.
Navigating the storm with confidence
In the face of soaring interest rates, stubborn inflation, and looming recessionary risks, quality growth investing emerges as a beacon of stability and resilience. Having a robust investment strategy that captures the best of traditional value investing and modern growth investing allows us to navigate the choppy waters of today’s economic landscape with confidence. The emphasis on consistent value creation and a disciplined approach to risk management makes quality growth investing an indispensable tool in any investor’s toolkit. If you wish to know more about the different investment products mentioned above, you may visit our POEMS website or head down to any of our 10 Phillip Investor Centres.
Wilfred Lim is head of strategy, investment solutions, at PhillipCapital
