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High Quality: The Sweet Spot Between Growth and Value

Brian BandsmaBy Brian Bandsma
Portfolio Manager and Senior Research Analyst
Vontobel Asset Management

Research shows that investors tend to be too optimistic about the future growth of high growth stocks, and too pessimistic about the growth of low growth stocks. Sitting in the middle, between growth and value, are businesses that generate growth well above the market average, with strong fundamentals and reasonable multiples – considering where rates are today. We consider these to be high quality stocks.

While it is fair to say that at some end of the market, valuations for growth have gotten out of touch with even reasonably optimistic expectations, opportunities still exist for investors looking for long-term compounded growth. Companies that exhibit characteristics such as pricing power, barriers to entry, or strong competitive advantages can lead to greater predictability of earnings.

Buying quality businesses usually requires a longer-term holding period. Quality businesses are generally not unknown to the market and usually demand premium valuations. The quality factors of a business allow it to compound at a more consistent rate over a longer period, which creates value for shareholders. By comparison, quantitative managers who may own these same stocks tend to sell out of them sooner given the shorter-term nature of their holding periods, meaning they tend to leave the real money these quality businesses can generate on the table.

Unprofitable Stocks Have Outperformed Profitable Stocks the Last Two Years - MSCI All Country World Index

Unprofitable Stocks Have Outperformed Profitable Stocks

Past performance is not indicative of future results. Indexed by profitability. January 1, 2019 = 100. The aggregated net income for last four quarters is used to define profitability. Companies with no net income data for all previous four quarters are ignored from the calculations. Sources: MSCI, IBES, FactSet, Bernstein Analysis.

Resist the Rotation Trap: Stick with Quality

At any given time, the extreme end of the market exists, where valuations are more speculative—especially new or emerging industries with limited track records. Electric vehicle makers and their suppliers or the latest crop of internet services companies continue to sell at valuations that are difficult to justify even under the most optimistic scenario. Investors could attempt to time the market, rotating from these more speculative growth stocks to value, but the stocks that make up the value bucket today are likely appropriately priced relative to their growth opportunities.

While such a rotation might make sense as a short-term trade, timing markets is a difficult, if not impossible, task for even the most experienced investors. A market rotation is not usually obvious until well into it, coupled with many false starts and stops. As we see it, buying high quality businesses that can compound earnings over time should let you sleep at night and is more likely to help generate above-market returns over the long term.

The commentary is the opinion of Vontobel Asset Management. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.

The MSCI All Country World Index (net) is a free float-adjusted market capitalization-weighted index that measures equity performance of developed and emerging markets. The index is calculated on a total return basis with net dividends reinvested. The index is unmanaged, its returns do not reflect any fees, expenses, or sales charges, and is not available for direct investment.

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