There are around fifty exchange traded funds (ETFs) in the world with a focus on quality. They are part of the Strategic beta family (commonly known as smart betas) and have the characteristic of focusing on companies with an established business model, a sustainable competitive advantage, a stable level of profitability and healthy balance sheets. According to Morningstar data, they manage approximately $12 billion in assets globally (as of June 30, 2016). In Italy, there are about ten replicants of this type to which are added the multi-factorial ones, which include, among others, the criterion of quality.
WHAT DOES QUALITY MEAN
These strategies select stocks based on indicators such as return on equity, return on invested capital or measures of a company's financial health. Morningstar, however, uses another metric, Economic moat, which indicates sustainable competitive advantage that protects profits from competition. Firms can have a wide moat, a narrow moat, or no moat at all.
Some sectors such as basic materials or energy have predominantly companies without a competitive advantage, while others (consumer defensives or pharmaceuticals) have many, as the graph below for European industry shows.
Source: Morningstar Direct. Data as of 8 December 2016.
QUALITY IS CYCLIC
"Like all investment factors, quality also has periods of popularity and decline," says Dan Lefkovitz, content strategist for Morningstar's indices segment. “The last year has been a case study in this sense”. “Since January, the European market has been 'no moat', but three years on 'wide moat' companies have done better than all the others,” says Fernando Luque, an analyst at Morningstar.
RETURNS OF EUROPEAN STOCKS PER ECONOMIC MOAT
BULL AND BEAR
Using the Morningstar indices which group US companies according to the economic moat, it is possible to extend the time horizon to the decade (there is no analogous historical series for Europe). “In bull markets, non-moat stocks get the best returns,” says Lefkovitz. “It happened in 2007, 2009-10 and 2012-13. Conversely, in bear periods, such as 2008, 2011 and 2015, wide moat stocks perform higher. We can call it 'migration towards quality', but also the solidity of well-structured business models capable of generating profits on an ongoing basis”.
EYE TO THE EVALUATIONS
What lesson to draw from this analysis? “Like any factor, quality is cyclical,” concludes Lefkovitz. “While it is believed to outperform in the long run, it can disappoint in the short term. Therefore, it is better not to invest only on the basis of this parameter. Stock valuations remain a key factor: investors shouldn't overpay for quality, but always keep the price/fair value ratio in mind."
Source: morningstar.it
