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Is offshore quality a crowded trade?

Two local fund selectors give their views on the dominance of quality in recent years.

Is offshore quality a crowded trade?

With so much uncertainty in investment markets across the globe, it’s no surprise that fund managers are looking to invest in quality stocks – companies with sound balance sheets, cashflows and stable earnings.

As Fatima Vawda, MD at 27four Investment Managers put it, investing in quality is a no-brainer.

In fact, a recent analysis by Citywire of the top holdings in South African fund of funds found that the three most widely-held global equity funds in local portfolios are the BCI Fundsmith Equity Feeder fund, the BlueAlpha BCI Global Equity fund and the Ninety One GSF Global Franchise fund. All three follow a quality strategy.

Is there is a risk, however, of this becoming a crowded trade?

Elevated valuations but still reasons to invest

‘Whether they’re crowded or not is a difficult call,’ said Vawda (pictured). ‘Also, it’s always difficult, if not impossible to predict inflexion points either on the upside or downside.

‘An aggressive rally in global quality stocks does put them at risk of some form of correction, but we don’t see that happening until a point where the Covid-19 threats diminish significantly. That can only happen when we have a vaccine or cure. We seem a very long way from that point.’

Vawda added that even if a correction happens, 27four is comfortable knowing that they are holding high-quality companies that will always deliver returns around the market average in the long run.

However, valuations of global quality companies are elevated.

‘At the end of August, the MSCI Quality Index was spotting a price to book ratio of 7.29 times, which is nearly three times higher that of the MSCI World Index,’ she said. ‘The PE ratio of the quality index is at around 25, which is also higher than the historical average for the sector.

Cyclical risks

‘The implication is that when leading indicators begin a new up-trend, economic activity stabilises, and investors become more willing to take up risk in lower-quality assets, a rotation from quality to pro-cyclical equity market segments may take place,’ said Vawda. ‘But we do not see quality stocks being subject to permanent losses in the long run. The innate characteristics of high-quality companies naturally result in stocks that exhibit a lower beta than the broader equity market.

‘There are cyclical risks to quality, but those risks will not be as pronounced as other styles, and will be temporary.’

Andries Kotzee, the CIO at Celerity Investments noted that something like high inflation could also be a risk, because one of the drivers of quality performance has been low-interest rates. This has attracted investors looking for yield.

While the days of the significant cuts in interest rates are likely behind us, Kotzee said we don’t know if this means quality stocks will no longer rise.

‘Inflation could be a risk. That is why we don’t put all our eggs in one basket.’

Celerity also has exposure to value.

The case for quality

‘Quality shares offer sustainable investing options because they have better cash flows and not a lot of debt,’ Vawda said. ‘Quality companies are a lot more resilient when there is uncertainty in capital markets and they are able to weather the storm much better than highly geared companies.

‘They also have a lower incidence of unfavourable events like cutting dividends.’

Kotzee (pictured) said the managers who have tended to perform over the last decade more often than not have been quality managers, hence the inclusion in the Celerity fund.

‘It has worked,’ he said. ‘More than a quarter of our allocation to active managers is to those investing in quality companies.’

Kotzee said part of the reason why quality has worked is because managers start off with a smaller universe and can really analyse companies and focus on finding the right ones to invest in.

‘It’s a universe managers can get their heads around, which gives them a better chance of identifying mispriced assets.’

Managers

Even if quality does go out of favour, this may not see selectors switching out of this style as they still have faith in the underlying managers.

‘I need to find managers who will identify mispriced assets and turn that into out-performance,’ said Kotzee. ‘Some of that may happen in quality stocks, some in rules-based investing (factor strategies), some may happen in value. We don’t know when which one will work, but we have a good idea which managers tend to get it right more often than they get it wrong.’

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Related Fund Managers

Andries Kotzee
Andries Kotzee Average Total Return:
3.21%
36/115 in Mixed Assets - Balanced ZAR (Performance over 1 year)
Fatima Vawda
Fatima Vawda Average Total Return:
0.94%
76/121 in Mixed Assets - Balanced ZAR (Performance over 3 months)
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