Quality investment for long-term wealth creation

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Consistency is one of the most important attributes of fund performance. Many mutual funds can perform well, i.e. beat market returns in certain market conditions, but they may not be able to outperform in certain other market conditions. For example, a high-beta stock may generate high returns in bull markets, but may experience a steep decline in volatile markets. Quality investing aims for consistency of performance across different market conditions and investment cycles. In this column, we will discuss what quality investing is, how quality investing has performed in different market conditions, and how it has performed over the long term.

What is Quality Investing?

Simply put, quality investing seeks to invest in the best companies. Some investment experts trace the origins of quality investing to fixed income securities, where a high credit rating (high quality) denotes companies that are financially stronger than others. There is no clear definition of what constitutes quality stocks. MSCI uses three metrics to identify quality stocks: a high return on equity (ROE); stable year-over-year (year-on-year) earnings growth; and low financial leverage (debt ratio).

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Different fund managers may use different factors to identify quality stocks. Among the quantitative factors, the factors mentioned above and other factors (eg free cash flow, higher operating margins, valuations, etc.) are used by fund managers. Fund managers also use qualitative factors such as market positioning, economic moats, business models, quality of management, etc., to assess quality.

Quality investing outperforms in the long run

The quality index has outperformed most years. What may interest many investors is the observation that quality has almost always outperformed in volatile markets.

Has quality investing outperformed in India?

Quality investing is a proven concept globally. But some of the investors are of the view that the equity market in India is different from the developed markets because it is largely a growth market. Let us see how quality investment has fared in India. The chart above shows the annual returns of the MSCI India Quality Index versus the MSCI India Index over the past 10 years (as of December 31, 2020).

You can see that even in India the quality index has outperformed most years. Years circled in red experienced relatively higher volatility than other years due to various factors viz. US sovereign rating downgrade (2011), taper tantrum (2013), eurozone debt crisis and economic downturn in China (2015) and covid-19 pandemic (2020). You can see that quality investments have outperformed in volatile market conditions. The performance of quality stocks over these periods has shown that these companies are better positioned to withstand long-term economic shocks over multiple investment cycles.

The long-term investment approach contributes to a quality investment

Quality stocks tend to deliver consistent financial performance regardless of investment cycles. Therefore, it is important to stay invested in these stocks over multiple investment cycles and benefit from the power of compounding under different conditions. As such, a quality investment can be a good strategy for investing in your long-term financial goals, whether for retirement planning, children’s higher education, child marriages, creating wealth, etc. Investors should consult their financial advisors about mutuals. fund schemes that follow the quality investment strategy.

Jinesh Gopani is Head of Equity, Axis Mutual Fund.

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