We all know the difference between Value Investing and Growth or Momentum investing. But there is another investing style called ‘Quality Investing’. Let us try to figure out what this style of investing is and how it compares itself with value investing.
Value, quality, momentum, low volatility, alpha, or a mix of these can all be used to guide investment strategies. Since value and quality focus on distinct aspects of a business, they are sometimes seen as competing strategies. While quality investing concentrates on businesses with solid financial foundations, value investing looks for stocks that are selling below their real worth and have the potential to rebound in value.
Therefore, quality investment highlights a firm’s long-term stability and resilience, whereas value investing focuses on finding price disparities. As a result, each method frequently results in distinct company picks.
The goal of value investing is to identify cheap stocks. Due to short-term barriers, market trends, or other variables that do not account for the company’s long-term prospects, investors seek for companies whose stock prices are below their intrinsic or fair worth.
The extent of undervaluation may be determined using common valuation indicators including low price-to-earnings (P/E), price-to-book (P/B), price-to-sales (P/S), and high dividend yield ratios. Since it may take some time for the market to completely acknowledge and represent a company’s actual value, this method of identifying undervalued companies requires endurance and patience.
The capacity to deliver superior returns on progressive capital, sound free cash flow (FCF), manageable financial leverage (low debt/equity ratio), high return on equity (ROE), return on capital employed (RoCE), and solid corporate governance are all examples of strong fundamentals that are typically displayed by businesses linked to a quality theme. Long-term solidity, consistent returns, reduced volatility, sound management, and profitable expansion are all results of these companies’ durable edge in the marketplace.
Purchasing high-quality stocks acts as a buffer during recessions. Strong balance sheets with less debt, lots of liquidity, and robust operating models enable quality companies to weather market turmoil. They may be industry leaders who have a track record of overcoming obstacles and coming out stronger. They are perfect for long-term investors looking for both capital preservation and growth, which facilitates compounding gains. Quality investments therefore provide a more cautious yet fruitful method of generating money, particularly during erratic market times.
But we have to keep in our mind that value investing does considers these factors as well while investing in companies. It’s not that value investors see only undervaluation and ignore other fundamentals. One of the prime examples for this is ‘Warren Buffett’, who is termed as the best value investor the world has produced so far.
None of these strategies produce consistent returns:
It is thought that over time, great performance might result from concentrating on a specific aspect. High commitment is frequently linked to concentrated investments, which are thought to improve performance. This might not always be the case, though. “Those who win rotate” is something that investors need to keep in mind. The sector or a company that performs the best now could not do so in the future, and vice versa. No one style delivers better results, year after year. For instance, before rebounding in 2021, the value style investing failed from 2018 to 2020. In a comparable way, the quality style investing has performed inconsistently in the last few years.
In the past, it has been noted that quality stocks do rather well in periods of uncertainty. For instance, in 2011, 2013, 2015, 2018, 2019, and 2020, the Nifty 200 Quality 30 Index did rather well. Interestingly, these years were all characterized by higher levels of uncertainty in the stock market.
Value stocks have done rather well since the start of 2024 this year. For example, from the start of the current year 2024, we can note that value theme was doing well as the markets were rising to higher levels. But since May 2024, there has been a lot of uncertainty in the market, first because of the general elections, then because of the budget, the Japanese-yen carry trade, the US economic contraction, geopolitical tensions like wars, and, more recently, concerns regarding foreign institutional investors moving their money from nations like India to China.
Since the best-performing industry now could not be the best one tomorrow, winners change places. We base the quality theme’s performance through Nifty 200 Quality 30 TRI index and value investing theme through Nifty 200 Value 30 TRI index.
For those who are unfamiliar with these indices, the Nifty200 Quality 30 Index seeks to include businesses that have a long-term business plan and operating model that leads to steady growth. Based on factors including return on equity, debt-to-equity ratio, volatility, increased profitability, less leverage, and more consistent profits, 30 firms are chosen from the Nifty 200 index (and reviewed semi-annually) to make up this index. Each stock’s weight in the index is determined by combining its free float market capitalization and quality score.
Similarly, the Nifty200 Value 30 index is made up of 30 firms from the main Nifty 200 index, chosen based on their ‘value’ rankings. The ratios of earnings to price (E/P), book value to price (B/P), sales to price (S/P), and dividend yield are used to calculate each company’s value ranking. The blend of a stock’s free-float market capitalization and value score determines a stock’s weight in the index.
Though Nifty 200 Quality 30 TRI index and Nifty 200 Value 30 TRI index have produced 9.4% and 17.5% compound annual growth rates, respectively, since its debut (debuted on April 1, 2005), it should be noted that their yearly results varied greatly due to the market movements and uncertainties. Hence we cannot pick one from this as a winner despite the fact that you may think value index is the winner here from this returns data. But again, it all depends on when you enter the market and how you stay invested through the course of the past periods.
Finally, keep in mind that a variety of factors combine to form the larger equity market. Investors must thus either select a factor-diversified portfolio or spread their equity investments over a number of themes with varying styles and factor-shifts in order to eventually establish a factor-diversified portfolio.
You may wonder, what exactly is a factor-diversified portfolio? It is a diversified portfolio of multiple distinct companies with differing levels of risk exposure created by combining the appropriate risk criteria such as value, quality, momentum, low volatility, size, dividend yield, cyclicality, and so on, giving the investor a higher chance of outperforming the market.
Over time, this strategy should help most investors have a better investment experience. So, for investors who are looking to make tactical calls on certain themes, always keep in your mind that (as we say in cricket) – “you have to reach to the pitch of the ball to hit it before the ball spins”.
